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>^HI 


Industrial  Securities 


by 


Hernann .  v .  Arena 


Industrial  Securities 


By 

HERMANN  F.  ARENS,  PH.D. 


Professor  of  Business   Economics,   Northeastern   College. 

Economics  Expert,  Babson  Statistical  Organization,  1916-19. 

Professor  of  Economics,  Babson  Institute,  1919-20. 


AMERICAN  INSTITUTE  OF  FINANCE 


Industrial  Securities 


By 


HERMANN  F.  ARENS,  PH.D. 


Professor    of    Business    Economics,    Northeastern    College. 

Economics  Expert,  Babson  Statistical  Organization,  1916-19. 

Professor  of  Economics,  Babson  Institute,  1919-20. 


AMERICAN  INSTITUTE  OF  FINANCE 
BOSTON 


OUR 

"COMPLETE   EDUCATIONAL   COURSE" 

IN  THE  SCIENCE  OF 

MAKING  MONEY  MAKE  MORE  MONEY 

This  list  is  arranged  in  the  order  of  proper  reading.  The 
books  are  accompanied  by  a  series  of  test  questions,  key  prob- 
lems and  analyses  outlines,  enabling  the  student  to  apply  the 
knowledge  acquired  to  immediate  stock  market  and  investment 
•conditions. 


1.  Developing  Financial  Skill 

2.  Forces  Which  Make  Prices 

3.  Manipulation  and  Market 

Leadership 

4.  Handling  a  Brokerage  Ac- 

count 

5.  Market  Information 

6.  The  Essential  Features  of 

Securities 

7.  The   Value  of  a  Railroad 

Security 


1 1 .  Investment  Securities 

12.  Business  Cycles 

13.  Measuring   and   Forecasting 

General    Business    Condi- 
tions 

14.  The  Technical  Position  of  the 

Market 

15.  Money  and  Credit 

16.  Business  Profits 

17.  Launching  a  New  Enterprise 

18.  Securing  Capital  for  Estab- 
lished Enterprise 


8. 

Industrial  Securities 

9. 

19.  Internal  Financial    Ala 
Oil  Securities                                        ment 

10. 

M  in  ing  Securities                     20.  Search  for  Bargains 

Copyright,   1922  by 
.      ,            American  Institute  of  Finance 

••    •  2  *2  •"••••••  •      •    .      . 

• •••••!!      •  •  •       *      .2  •    •      •••••! 

•  •....    .  •.•      «  *.  .•     ...... ; 

•    •   •   .  .  . 

•••••••    

.••   ..*    :  .:  "  4. •  ••  •      •".  •••     

..      .      •      ;  ••  •  2  ••   •  •        •••<      !      •     •• 

•     «  .».      . 


•    .*.  .  .  ••;  .••  •    • 


A 


TABLE  OF  CONTENTS 


Chapter  I.     Our  Industrial  Development  pafee 

Industrial  Conditions  Three  Centuries  Ago 5 

The  Industrk.1  Revolution 5 

What  Caused  the  "Industrial  Revolution" 6 

Growth  of  Markets 6 

Corporate  Organization  Appears 7 

Industrial  Corporations  to  the  Fore 8 

Motives  for  Consolidation 8 

Development  of  Combinations 9 

■  •culation  in  Industrials 10 

Increasing  Publicity  for  Industrial  Companies 11 

Causes  of  Stock  Dividends 12 

Chapter  II.     Management  and  the  Personal  Element 

Character  of  Enterprise 13 

Knowledge  of  Men  Important 13 

The  Calibre  Xecessary 14 

Financial  Support 15 

Chapter  III.      Individual  Factors 

I  )ividenda  Paid        16 

Value  of  a  Strong  Working  Capital 17 

Banking  Interests  Often  Friendly 18 

Reorganized  Companies  Attractive 19 

New  Enterprises 19 

x               Difficulties  of  Boom  Periods 20 

V'               Location  of  Prime  Importance !1 

^  j                  Ownership  of  Raw  Materials 21 

va  Chapter  IV.  Advantagi  -\u<\  Disadvantages  of  Indus- 
trial Set  unties  from  the  Standpoint  "I  the  Trader 
or  Speculator 

ition  of  the  Speculate-!        22 

Greater  Risk  —  Greater  Profit 

Profit  Facte) !3 

Fluctuations  in  Profits !  I 

Growth  an  All-important   Firtnr         25 

A  Virile  Organization  Necessary 26 


44  7 472 


4  Table   of  Contents 

Chapter  V.     Advantages  and  Disadvantages  of  Industrial 

Securities  as  Investments  pafee 

Position  of  Common  Stockholder 28 

Position  of  Bondholder 28 

Stability  of  Demand  and  Diversification 29 

Character  of  Demand 30 

Prospects  of  Growth 30 

Preferred  Stocks 30 

Chapter  VI.     The  Balance  Sheet 

Difficulties  in  Studying 32 

Holding  Companies  Particularly  Difficult 32 

The  Use  of  Statements 33 

The  Typical  Balance  Sheet 34 

The  Assets  Side        .      .      .      .  ' 35 

The  Liabilities  Side 36 

The  Individual  Items 36 

Patents,  Trade  Marks  and  Good-will 37 

Investments 38 

Current  Assets 38 

Accounts  Receivable 39 

Fixed  Liabilities 40 

Working  Capital _ 40 

Current  Liabilities 41 

Chapter  VII.     The  Income  Account 

Points  to  Get 42 

Expenses  of  Doing  Business 43 

A  Typical  Income  Account 43 

Effects  of  Taxation 45 

Difficulties  in  Judging  an  Income  Account 46 

Effects  of  Changing  Conditions 47 

Chapter  VIII.     Analyzing  Consecutive  Balance  Sheets 

Use  of  a  Concrete  Example 49 

A  Poor  Situation 49 

Some  Important  Changes 50 

Reduction  in  Debt  Marked 50 

Turning  Goods  into  Money 51 

A  Further  Strengthening 51 

The  1916  Year 52 

A  Very  Strong  Position 53 

The  Transition  Completed      ... 53 


CHAPTER  I 
OUR    INDUSTRIAL    DEVELOPMENT 

Industrial  Conditions  Three  Centuries  Ago 

Three  hundred  years  ago,  the  economic  and  industrial  life 
of  the  people  of  Western  Europe  presented  little  variation  as 
between  one  country  and  another,  or  as  between  different  sections 
of  the  same  country.  The  great  bulk  of  the  population  was 
employed  on  the  land  extracting  from  the  soil  grain,  vegetables 
and  flax;  herding  the  sheep  and  cattle,  tending  the  hogs  and  hens; 
mining  from  the  earth  the  basic  necessities  of  human  life. 

In  each  village  the  blacksmith  furnished  what  iron  work  was 
needed.  He  made  weapons,  and  wheel  rims,  and  shod  horses.  He 
also  made  nails,  bolts  and  hinges,  all  by  hand.  The  mason  and 
the  carpenter  performed  their  constructive  functions  as  today. 
The  shoemaker  made  shoes  as  well  as  repairing  them. 

As  would  be  expected  under  such  circumstances,  living  was 
simple  and  meagre.  No  large  populations  could  exist,  because 
-ii<  h  a  simple  economic  organization  could  not  furnish  the  means 
ot  feeding,  clothing  and  sheltering  many  people  on  the  limited 
3upply  of  land  which  Western  Europe  provides. 

Wli.it  a  picture!  What  a  contrast  with  the  economic  organi- 
/.it ion  of  today! 

The  Industrial  Revolution 

The  change  from  the  simple  economic  organization  ol  the 
six i ecu th  ecu i  my  to  the  complicated  .mil  sensitive  <  irganizal  ion 
ot  today  is  known  as  the  Industrial  Revolution.  h  comprises 
the  growth  ol  large»scale  indusl  ry,  the  factory  system,  the  devel- 
opment ot  1 1, inking  and  transportation;  the  revolution  in  agricul- 
tural and  mining  methods;  the  discovery  and  exploitation  of 
coal,  oil,  th i  team  engine  and  electricity,  and  mon  recentlj  the 
internal  combustion  engine  and  ili<-  mastery  ol  the  air. 


6  Indus  trial  Securities 

With  all  this  has  come  the  development  and  extension  of 
industrial  organization  and  corresponding  expansion  and  diversi- 
fication of  the  security  markets  in  which  industrial  securities 
have  within  the  last  few  years  attained  such  prominence. 

What  Caused  the  "Industrial  Revolution?" 

The  usual  answer  is  the  invention  of  the  steam  engine,  or  the 
invention  of  the  factory  system.  Another  favorite  answer  is  the 
improvement  in  transportation  both  on  land  and  sea.  These  do 
not  answer  the  question  as  to  time.  Why  did  the  Industrial 
Revolution  start  when  it  did  instead  of  two  centuries  earlier — or, 
perhaps,  two  centuries  later? 

The  answers  given  above,  moreover,  fail  to  explain  the  cause 
as  well  as  the  time.  That  the  multitude  of  inventions  and  im- 
provements in  technical  processes  and  economic  organizations 
should  have  been  born  in  the  last  two  centuries  is  certainly 
marvelous  and  must  have  had  a  powerful  cause.  It  cannot  be 
that  human  intellect  is  vastly  superior  now  to  what  it  was  some 
years  ago,  or  that  before  1750,  or  thereabouts,  men  were  slow  of 
mind  and  stupid.  To  attribute  the  beginning  of  this  great 
movement  to  accident  is  merely  to  give  up  the  attempt  to  explain. 

Growth  of  Markets 

The  true  explanation  is  found  in  the  enlargement  of  markets. 
The  discovery  of  America  was  followed  in  the  sixteenth,  and 
especially  in  the  seventeenth,  century  by  the  exploitation  of  the 
mines  of  Peru  and  Mexico,  and  millions  upon  millions  in  silver 
and  gold  came  to  Spain,  robbed  from  the  natives  of  America. 
Portugal  also  took  a  share  and  the  way  was  opened  by  sea  to  the 
markets  of  India  and  the  Far  East.  The  possessors  of  the  treasure 
from  America  hastened  to  spend  the  money  for  goods  of  all 
sorts,  while  trade  with  the  Far  East  brought  new  wealth  to 
Holland,  Britain,  and  Portugal. 

The  initial  force  that  started  thegreat  Industrial  Revolution  is 
thus  seen  to  have  been  a  new  and  powerful  demand  for  goods. 
In  response  to  this  demand  came  the  invention  of  the  mariner's 


0  it  r    Industrial   Development  7 

compass,  improvements  in  shipbuilding  and  sailing  to  give 
greater  safety,  greater  cargo  space,  and  greater  speed.  On  land, 
the  factory  system  was  invented  to  give  greater  production,  to 
supply  the  new  markets  which  now  offered  profitable  prices: 
machines  to  increase  the  productivity  of  human  labor,  power  to 
drive  the  machines,  good  roads,  canals  and  railroads  to  answer 
the  demand  for  cheap  and  safe  transportation.  All  these  inven- 
tions and  improvements  in  the  technical  processes  of  production 
came  in  answer  to  the  incessant  demand  for  more  goods  offering 
the  lure  of  more  profit. 

The  Revolution  started  in  Britain  because  there  the  measure 
of  industrial  freedom  was  greatest,  and  Britain  shared  but  little 
in  the  gold  and  silver  from  America.  The  Spaniards  who  brought 
the  gold  were  content  to  buy  what  they  wanted  and  cultivate  a 
life  of  genteel  indolence,  but  Britain  bought  her  share  by  industry. 

The  process  once  started  was  cumulative  and  as  new  inven- 
tions were  made  and  new  lands  opened,  opportunities  increased 
and  living  conditions  improved,  making  new  demands  for  the 
products  of  industry.  Wherever  the  freedom  of  business  enter- 
prise extended,  a  new  class  of  "business  men"  or  business  enter- 
priser- became  the  keystone  of  the  economic  arch. 

Corporate  Organization  Appears 

Until  the  middle  of  I  he  19th  century  pracl  ically  all  t  he  manu- 
fa<  turingor  merchandising  enterprises  were  managed  by  individ- 
ual enterprisers  or  as  pari  nerships.  Family  enterprises  were  the 
mosl  common.  Two  or  three  brothers  or  a  father  and  his  sons 
undertook  business  together.  The  corporate  form  oi  organiza- 
tion wa  re  erved  for  undertakings  so  greal  thai  no  small  group 
of  private  enterprisers  could  be  found  willing  or  able  to  supply 
all  the  capital  needed  or  to  take  all  the  business  risk.  Such,  for 
example,  were  the  greal  trading  and  colonizing  companies,  the 
Dutch    I..1-1     India    Company,   and    the    British    Easl     India 

(   ompaiiv. 

The  corporate  form  of  organizal  ion  was  really  broughl  to  the 
fore  by  the  introdu<  tion  oi  the  Jteam  railroad.     Railroad  enter 
prise  required  large  amounts  of  capital  ami  in  their  early  da 


8  /  n  (I  it  s  t  r  i a  I  S e  c  u  r  it ie s 

wore  considered  too  risky  an  enterprise  to  justify  the  partners, 
even  of  a  wealthy  business  partnership,  in  risking  their  all  on 
such  a  new  thing. 

This  brought  a  large  amount  of  railroad  securities  into  ex- 
istence. They  became  the  most  attractive  medium  of  speculation. 
Before  their  appearance,  the  usual  medium  of  speculation  had 
been  the  bonds,  consols  or  rentes  of  the  various  national  govern- 
ments and  the  shares  in  the  great  trading  companies. 

From  1830  to  1890,  the  great  railroad  systems  throughout 
the  world  were  being  built.  The  securities  of  cities,  states  and 
empires  simultaneously  retired  from  the  center  of  the  speculative 
stage.     They  moved  into  the  investment  class. 

Industrial  Corporations  to  the  Fore 

Meanwhile  great  industrial  enterprises  were  growing  up.  At 
first  partnerships  were  turned  into  corporations  purely  for  con- 
venience and  in  order  to  escape  the  burden  of  unlimited  liability. 
If  a  partner  dies,  the  firm  ceases  to  exist  and  must  be  liquidated  or 
another  partner  must  be  found  to  take  over  the  interest.  The 
death  of  a  stockholder  in  a  corporation  has  no  immediate  effect 
on  the  business.  A  corporation  is  a  legal  personality  and  goes 
right  on.  While  perceiving  the  advantages  of  the  corporate 
form  and  in  many  cases  changing  to  that  form,  most  industrial 
enterprises  remained  close  corporations,  family  affairs,  just  as 
before  incorporation. 

It  is  only  with  the  coming  in  of  large-scale  industry  dominated 
by  the  economic  law  of  "increasing  returns"  that  the  stock 
became  distributed  beyond  a  limited  circle  and  was  "listed"  and 
traded  in  on  the  exchanges.  The  movement  toward  expansion 
and  the  integration  of  smaller  units  into  the  large-scale  industrial 
corporations  began  in  the  late  70's. 

Motives  for  Consolidation 

There  were  two  motives  drawing  the  small- and  medium-scale 
industrial  establishments  toward  consolidation.  One  was  the 
well-known  economics  of  large-scale  production.     When  several 


Our   Industrial   Development  9 

manufacturing  plants  unite  under  one  management  a  number  of 
economies  are  often  possible.  Chief  among  these  are  the  follow- 
ing: 

1.  The  possibility  of  purchasing  in  larger  quantities  at  lower 

cost. 

2.  A   wide   market,    hence   less   fluctuation    in    demand    for 

products. 

3.  The  elimination  of  poorly  situated  plants  in  favor  of  the 

more  favorably  situated. 

4.  The  possibility  of  securing  highest  grade  of  men  in  all  de- 

partments and  using  each  high-grade   man  to  his  full 
capacity  in  the  work  he  does  best. 

5.  Utilization  of  by-products  that  would  not  pay  on  a  small 

scale. 

6.  Elimination  of  cross  shipments. 

7.  A  large  corporation  because  of  its  prominence  and  large 

resources  and  greater  stability  has  a  great  advantage  in 
financing  over  the  small  and  local  corporation. 

Hut  the  possible  economies  of  large-scale  production  did  not 
constitute  the  only  or  perhaps  the  chief  motive.  More  promi- 
nent in  the  minds  of  those  who  brought  about  these  combinations 
was  the  lure  of  getting  rid  of  competition  and  securing  something 
approaching  a  monopoly. 

Development  of  Combinations 

The  in-'    form  which  these  COmbina  I  ions  look  was  thai   of  a 

holding  trust  under  which  all  the  stockholders  of  the  various 
companies  deposited  their  stock  with  a  board  ol  trustees  who 
operated  all  the  plants  in  the  interests  ol  the  common  pool. 
Hostility  to  these  "trusts"  ultimately  forced  their  dissolution. 

Then  followed  the  organization  of  holding  companies.  Until 
1X71  the  weigh  1  of  courl  authority  both  in  Greal  Britain  and  the 
United  States  was  againsl  t  he  power  ol  one  corporal  ion  to  become 

hareholder  in  another  unless  Buch  power  was  expressl)   con 
fened  bylaw.      In  1869,  \eu  Jersey  passed  the  famous  consti- 
t  u  t  ional  amend  men  1  permil  ting  such  a  step. 


ni  /  ;/  (1 11  s  /  r  i a  I  S e  cur i ties 

Two  well-known  examples  will  serve  to  illustrate  the  prog- 
ress in  the  formation  of  the  great  industrial  combines.  The 
Standard  Oil  Trust  was  formed  in  1879.  In  1892,  this  trust  was 
superseded  by  a  holding  company,  the  Standard  Oil  Co.,  of  New 
Jersey,  with  a  capital  of  ten  million.  In  1899,  this  company 
increased  its  capital  from  ten  million  to  one  hundred  and  ten 
million,  treating  the  original  ten  million  outstanding  as  preferred 
stock. 

The  U.  S.  Steel  Corporation  was  formed  in  1901  from  the 
Carnegie  Steel  Co.,  the  National  Steel,  Illinois  Steel,  American 
Steel  Hoop,  American  Wire  and  Steel,  National  Tube  and  others. 
From  1901  the  consolidation  movement  progressed  rapidly  and 
drew  hostile  public  attention  which  resulted  in  the  enactment  of 
the  Sherman  Anti-Trust  Law  and  Federal  prosecutions.  In 
spite  of  public  hostility  the  formation  of  giant  corporations  went 
on  and  one  field  of  industry  after  another  has  been  invaded. 

Speculation  in  Industrials 

Up  to  1910,  the  overwhelming  volume  of  speculation  was  in 
railroad  stocks,  and  railroad  bonds  were  the  most  prominent 
investment  securities.  By  1910,  the  "industrials,"  led  by  U.  S. 
Steel,  were  coming  to  the  front  and  attracting  public  attention. 
The  Interstate  Commerce  Commission  and  the  Railroad  Commis- 
sions of  the  several  States  were  drawing  the  net  tight  around  the 
operations  of  all  railroad  systems.  This  came  at  a  time  when, 
from  economic  reasons,  the  operation  of  the  railroads  was  becom- 
ing difficult. 

Industrial  corporations  were  not  subject  to  these  limitations. 
Inside  information  for  those  "in  the  know"  offered  a  splendid 
opportunity  for  profit.  Then  came  the  war  boom.  Prices  rose 
rapidly,  demand  proved  insatiable  and  there  was  little  govern- 
ment control  over  prices.  The  railroads,  on  the  other  hand, 
could  not  raise  their  rates  without  permission  of  government 
authorities  and  they  faced  increasing  costs  of  operation  through 
the  rise  in  costs  of  material  and  labor.  The  spectacular  rise  in 
Bethlehem  Steel  from  40  to  800  focussed  public  attention  and 
attracted  the  speculative  fraternity. 


Our    Industrial   Development  11 

Increasing  Publicity  for  Industrial  Companies 

But,  with  this  development  among  the  industrials,  the  demand 
for  publicity  in  regard  to  financial  conditions  and  earnings  has 
become  strong.  Practically  all  industrial  corporations  whose 
stock  is  listed  on  the  exchanges  now  furnish  detailed  financial 
statements  at  least  yearly,  and  many  issue  such  statements 
quarterly.  Even  with  these  statements,  however,  keen  dis- 
crimination is  still  necessary  because  financial  statements  are  by 
no  means  proof  against  juggling.  When  a  large  corporation 
presents  a  statement  involving  the  financial  accounts  of  numer- 
ous subsidiaries,  it  is  difficult  even  for  an  accountant  to  get  be- 
neath the  surface.  There  are  innumerable  ways  in  which  assets 
can  be  concealed  or  inflated  as  desired,  and  it  is  obviously  im- 
possible for  the  average  investor  or  speculator  to  get  much  more 
real  information  than  the  management  wishes  to  give  out. 

The  internal  revenue  laws  have  done  wonders  in  improving 
and  standardizing  corporation  accounting.  By  forcing  every 
corporation  to  render  an  annual  account,  following  certain 
principles,  the  statements  of  corporations,  both  large  and  small. 
have  been  rendered  more  uniform  and  reliable,  and  publicity 
encouraged.  By  allowing  a  firm  to  earn  8%  profil  on  "invested 
capital"  free  of  excess  profits  tax  a  powerful  inducemenl  is  offered 
to  .ill  business  firms  to  increase  in  c\  ery  way  possible  the  amounl 
of  "in\ ested  capital." 

One  way  t<>  accomplish  t  hi-  is  in  turn  earnings  hack  into  the 
business.  If  the  stock  "I  .1  corporation  is  held  in  mosl  pari  by 
men  of  large  income  in  other  words  is  in  strong  hand-  and 
if  the  earnings  be  distributed  in  the  form  of  dividends,  the 
amounts  30  distributed  will  serve  to  swell  the  incomes  and  hence 
increase  the  3url  of  the  wealthy  recipients.      On  the  other 

hand,  if  the  earnings  are  spent  for  new  buildings  or  equipment,  or 
in  some  way  rci. lined  in  the  business,  1  considerable  amounl  is 
thereby  saved  t<>  tin-  stockholders  i<>  be  distributed  some  time  in 
the  future  when,  it  is  hoped,  surtaxes  will  be  no  more.  Meanwhile, 
the  "invested  capital"  swollen  by  the  re-invested  earninj 
furnishes  a  larger  base  upon  which  !  ire  the  8*  ,'   exemption. 


12  Industrial   Securities 

Causes  of  Stock  Dividends 

It  is  evident  that  this  policy  of  re-investing  earnings  must 
result  in  increasing  the  value  of  the  stock.  This  has  two  disad- 
vantages. It  attracts  public  attention  to  large  profits,  invites 
public  hostility  of  one  kind  or  another,  and  by  making  the  price 
per  share  unduly  large  restricts  trading  and  hurts  the  market  for 
the  stock.  To  remedy  the  latter  difficulty  and  partially  smooth 
over  the  former,  many  very  successful  industrial  companies  have 
split  up  the  shares  by  the  issue  of  two  or  three  shares  for  one  in 
the  form  of  a  stock  dividend.  Examples  of  this  are  Bethlehem 
Steel  and  General  Motors.  These  stock  dividends  are  not 
taxable  since  dividing  a  share  of  stock  into  two  or  a  hundred 
parts  adds  nothing  to  the  income  of  the  holder.  If,  however,  he 
elects  to  sell  any  of  his  shares  he  is  taxed  upon  whatever  profit  he 
may  have  made,  if  any,  upon  the  proportion  of  his  total  holdings 
which  he  has  sold,  regardless  of  the  number  of  shares  into  which 
that  proportion  has  meanwhile  been  divided. 


CHAPTER  II 
MANAGEMENT   AND   THE  PERSONAL    ELEMENT 

Character  of  Enterprise 

The  management  of  any  business  enterprise  will  depend 
entirely  upon  the  men  who  are  the  real  business  enterprisers,  the 
men  who  plan,  initiate  and  carry  on  the  business  and  assume 
responsibility.  A  business  like  the  express,  telephone,  telegraph 
or  electric  service  depends  to  a  much  smaller  degree  on  the  factor 
of  business  enterprise  than  does  an  industrial  enterprise.  Any 
business  that  is  well  established,  systematized  and  reduced  to  a 
routine  can  be  carried  along  with  a  minimum  exercise  of  the 
elements  that  go  to  make  up  the  factor  of  business  enterprise. 

Plain  honesty  is  the  most  important  element  of  management 
in  all  business  but  in  these  lines  it  is,  with  ordinary  common 
sense,  almost  the  only  quality  necessary.  During  the  construc- 
ts e  period  of  railroad  history,  planning,  judgment  and  all  the 
other  qualities  of  business  enterprise  were  highly  necessary,  bul 
now  that  the  railroad  systems  have  been  built,  the  experiments 
tried  and  the  service  to  a  large  degree  standardized  the  rail- 
road business  is  tending  toward  the  same  degree  of  standardiza- 
tion thai  characterizes  the  express,  telegraph  or  electric  service. 

Knowledge  of  Men  Important 

I'm  in  the  industrial  field  the  qualities  of  business  enterprise 
are  all-important.  Good  managemenl  has  brought  success  to 
many  .1  doubtful  looking  proposition  and  main-  ol  the  most 
promising  have  been  wrecked  by  poor  management.  It  follows 
1 1 1. 1 1  a  knowledge  of  1  he  men  who  are  1  lie  real  1  ontrolling  pow<  1 
is  more  importanl  than  any  other  knowledge  thai  can  be 
obtained.  Such  names  .1-  John  I  >.  Rockefeller,  Judge  Gary, 
I  igget  1 ,  Wool  won  h,  Kresge,  and  Whelan,  in  1  heir  respei  tive  lines, 
have  stood  for  mu<  h.     These  men  and  manj  others  ol  like  ability 


14  Industrial   Securities 

have  formed  the  character,  intelligence,  industry,  and  much  of  the 
ability  of  the  corporations  with  which  they  are  associated.  It  is 
one  man  or  a  small  group  of  men  that  constitute  the  inmost  soul 
of  any  industrial  corporation.  Tf  the  speculator  can  find  out 
who  these  men  are  and  study  their  records  he  has  the  best  guide 
to  the  success  or  failure  of  the  enterprise. 

The  Calibre  Necessary 

It  is  not  enough  that  a  man  has  been  successful  in  the  manage- 
ment of  a  small  enterprise.  Many  a  man  that  could  manage  one 
store  successfully  is  lost  when  he  undertakes  to  manage  a  chain 
of  stores.  A  man  often  succeeds  in  managing  a  small  enterprise 
because  he  can  attend  personally  to  all  the  details.  When  put  in 
charge  of  a  big  business,  he  tries  to  follow  the  same  tactics  and 
finds  himself  swamped  under  a  mass  of  details  and  petty  dis- 
cussions, while  the  big  things  slip  away  from  him  or  else  his  health 
breaks  down  in  the  effort  to  handle  it  all. 

To  be  a  successful  military  commander  it  is  not  at  all  neces- 
sary that  a  man  be  a  good  grenade  thrower,  a  good  gun  pointer  or 
an  expert  with  the  bayonet.  He  must  be  able  to  grasp  a  big 
situation  as  a  whole  and  keep  things  in  their  proper  relations. 
He  must  be  a  leader  of  men,  able  to  pick  competent  men  and 
delegate  responsibility  to  them,  reserving  to  himself  decisions  on 
important  matters  and  the  co-ordination  of  the  functions  of  the 
officers  under  him.  It  is  the  same  in  the  management  of  a  large 
industry. 

Many  men  who  are  successful  in  one  line  fail  when  they  under- 
take to  manage  a  business  with  which  they  are  not  familiar,  but 
first-grade  business  men  do  not  often  make  this  mistake. 

No  man  is  safe  to  follow  unless  he  is  honest.  One  who  is 
crooked  in  his  business  methods  sometimes  succeeds  in  getting 
away  with  a  considerable  amount  of  money  for  himself,  but  those 
who  follow  him  and  those  who  are  associated  with  him  in  his 
ventures  are  almost  certain  to  come  out  wrong.  It  is  quite 
possible  for  any  speculator  or  investor  who  contemplates  the 
purchase  of  an  industrial  security  to  inquire  as  to  the  man  or  men 


Management   and    Personal  Element     15 

who  are  the  real  enterprisers,  the  real  managing  heads  and  look 
up  their  records. 

Many  a  wise  speculator  has  ridden  to  success  and  large  profits 
by  hanging  to  the  coat-tails  of  some  man  of  superior  genius.  It  is 
easy  to  see  what  profits  one  would  make  who  clung  steadfastly  to 
the  securities  of  those  companies  in  which  Harriman  or  Rocke- 
feller were  known  to  be  heavily  interested.  Of  course,  it  is  not 
possible  to  pick  a  winner  before  a  man  has  shown  his  ability,  but 
there  is  usually  a  considerable  portion  of  a  man's  active  life  left 
after  he  has  become  a  demonstrated  success. 

Financial  Support 

Strong  men  are  able  to  insure  financial  support  to  the  indus- 
tries they  father.  The  early  years  of  any  business  enterprise  are 
always  a  critical  period.  This  is  especially  true  if  the  enterprise 
is  started  during  a  period  of  prosperity.  Starting  under  aus- 
picious circumstances,  when  business  falls  of!"  and  prices  decline, 
the  new  firm  is  very  likely  to  go  to  the  wall  unless  it  has  strong 
financial  support.  We  have  already  seen  this  situation  develop 
in  main-  so-called  "war  babies." 

Perhaps  the  best  illustration  of  strong  financial  backing  and 
extraordinary  management  among  our  new  industrial  corpora- 
tions is  the  American  International  Corporation.  Here  is  a 
corporation  with  almost  unlimited  fields  and  possibilities.  It 
was  chartered  t<>  engage  in  the  import  and  export  trade,  to  sell 
American  materials  and  machinery  abroad,  to  furnish  American 
capital  and  American  engineers  where  needed  and  to  trade  in  the 

unties  ol  contributing  companies.  Fifteen  subsidiarii  are 
owned  and  controlled.  Ms  ownership  of  stock  in  the  New  York 
Shipbuilding  Company,  the  [nicni.itioii.il  Mercantile  Marine 
Company,  U.S.  Rubber  Company  and  l  nited  Fruil  Company 
diversity  ol  interest.  On  its  board  of  directors  are 
Messrs.  Vanderlip,  Franklin,  Kahn,  Stone,  Ryan,  Corej  and 
formerly  Judge  Lovetl  and  Theo.  V  Vail.  The  <  ompany  has  the 
backing  ol   the  National  City  Bank.      With  such  banking  and 

management  it  is  difficult  to  c< live  of  this  company's  failing 

for  la<  1.  "I  funds  or  because  ol  pom-  management,  although  it  is 
bound  to  have  il    revei  al    lik<  all  othei  , 


CHAPTER  III 
INDIVIDUAL   FACTORS 


Dividends  Paid 


The  factors  concerned  with  any  individual  firm  as  distin- 
guished from  those  involving  the  industry  as  a  whole,  are  chiefly 
concerned  with  the  problems  of  management.  The  ordinary 
investor  or  speculator  who  is  not  intimately  connected  with  the 
affairs  of  the  company  has  little  means  of  following  these  matters 
in  detail.  For  this  reason,  his  best  assurance  of  good  manage- 
ment, as  we  have  said  before,  must  come  from  a  knowledge  of  the 
business  ability,  honesty  and  past  records  of  the  men  in  control. 

There  are,  however,  certain  broad  outlines  upon  which  infor- 
mation is  easily  available  in  the  case  of  large  corporations  whose 
securities  are  traded  in  on  the  leading  exchanges.  The  statements 
published  by  these  companies  from  time  to  time  are  useful  for 
purposes  of  comparison,  and  if  taken  over  several  years  will 
indicate  something  as  to  the  policies  which  are  being  followed. 

Many  corporations  at  their  inception  had  no  material  value 
whatever  behind  their  common  stocks.  Such  was  the  case  with 
the  U.  S.  Steel  Corporation  and  the  Woolworth  stores.  These 
common  stocks  were  originally  "all  water."  But  it  has  been  the 
policy  of  both  companies  to  pu  t  a  large  proportion  of  earnings  back 
into  the  business  and  thus  pile  up  an  equity  that  gave  a  steadily 
increasing  value  to  the  common  stock.  Periods  of  depression  are 
bound  to  come,  and  a  company  that  pays  out  all  its  earnings  when 
earnings  run  high  is  sure  to  be  in  a  very  poor  position  when  de- 
pression comes,  sales  fall  off,  and  the  value  of  inventories  shrinks. 

If  successive  statements  show  that  a  company  is  paying  out 
all  it  possibly  can,  that  fact  may  be  taken  as  pretty  good  evidence 
that  the  insiders  are  unloading  the  stock  and  selling  out  their 
interests.  This  is  a  development  that  should  be  watched  in  new 
flotations.  Almost  invariably  good-will  and  sometimes  old  debts 
are   capitalized,   particularly  during   periods  of  prosperity.     If 


Individual    Factors  17 

large  dividends  are  paid  immediately  on  the  common  stock 
issued,  money  that  might  prove  a  valuable  asset  later  will  be  used 
up.  The  purpose  of  the  large  dividends  many  times  is  to  make 
the  stocks  look  attractive.  Such  a  move  is  certain  to  be  followed 
sooner  or  later  by  a  severe  decline  in  the  price  of  the  stock. 
Furthermorei  it  may  lead  to  financial  difficulties  and  a  receiver- 
ship in  due  course  of  time. 

One  of  the  best  illustrations  is  Columbia  Graphophone. 
During  the  war  boom  this  company  increased  its  common 
stock  outstanding  from  150,000  shares  to  1,500,000  shares  and 
in  October,  1920,  it  again  increased  it  to  3,000,000  shares. 

Dividends  paid  in  the  same  period  increased  from  $344,991 
in  1916  to  $2,435,402  in  1919. 

In  February,  1922,  the  company  practically  went  into 
receivership. 

Value  of  a  Strong  Working  Capital 

To  the  extent  that  a  business  firm  lacks  a  large  working 
capital  its  position  is  weakened.  Lack  of  a  sufficient  fund  of 
ready  cash  to  take  up  its  cash  discounts,  pay  its  help,  and  carry 
customers  who  run  accounts,  makes  it  depend  on  the  banks  for 
ready  money.  This  is  true  regardless  of  the  amounl  <>r  high 
quality  of  the  fixed  assets.  While  business  is  good  and  earnings 
high,  money  is  also  easily  obtainable,  but  in  time  of  stringency, 
when  prices  are  falling  and  profits  declining,  the  banks  may  be 
unable  or  unwilling  to  lend.  The  greater  the  firm's  need  the  l< 
u  tiling  i  he  banks  arc  likely  to  be. 

Furthermore,  a  weak  financial  posit  inn  puts  a  company  at  the 
mercy  of  the  haul;-,  al  all  times.  It  thru  becomes  especially  im- 
port.mi  thai  the  men  who  control  the  banks  should  be  friendly 
to  the  <  ompany.  The  bankei  have  the  opportunity,  espe<  ially 
in  time  of  3tress,  to  obtain  practical  control  of  the  industrial 
corporation  thai  is  in  a  position  oi  pronounced  dependency. 
Colorado  Fuel  and  Iron  would  have  perished  long  since  excepl 
for  the  facl  thai  powerful  bankers  were  interested  and  gave 
support.  American  Linseed  and  <  orn  Products  were  nursed 
along  for  years  l>v  -iron-  financial  intere  ts  until  conditions 
developed  thai  were  very  favorable  to  their  operation. 


18  1 11  d it  s  /  r  i a  I  S ecurities 

The  Allis-Chalmers  Company  was  strong  in  capital  assets 
even  when  it  failed.  But  business  was  dull  and  the  great  plant 
did  not  earn  its  upkeep.  Everyone  with  common  sense  knew 
that  sometime  demand  would  develop  and  the  plant  would 
become  anearner  again,  but  in  the  meantime,  had  the  corporation 
possessed  the  backing  of  Standard  Oil  or  the  Morgan  banking 
interests  the  necessary  money  would  doubtless  have  been  forth- 
coming to  carry  through. 

This  causes  us  again  to  refer  to  the  fact  that  it  is  of  the  first 
importance,  in  judging  the  present  condition  or  future  prospects 
of  any  individual  concern,  to  know  who  owns  the  stock,  and  the 
facts  regarding  their  financial  strength  and  banking  connections. 
The  men  associated  with  the  management  of  the  American  Inter- 
national Corporation  cannot  prevent  a  period  of  business  de- 
pression from  coming  in  its  due  course;  they,  therefore,  cannot 
prevent  the  International  Corporation  from  seeing  comparatively 
lean  years,  but  they  do  represent  financial  interests  and  financial 
institutions  of  great  strength  and  it  is  quite  unlikely  that  such  a 
corporation  would  go  to  the  wall  for  lack  of  banking  support. 

Banking  Interests  Often  Friendly 

Whenever  current  liabilities  are  greater  than  current  assets  a 
company  has  no  working  capital  at  all.  It  is  then  completely  in 
the  hands  of  the  banks.  If  these  be  friendly  it  may  still  be 
carried  along.  It  has  sometimes  developed  that  in  such  a  situa- 
tion the  stock  may  prove  to  be  a  good  speculative  purchase. 

If  the  banks  are  friendly  and  the  stock  very  low  the  big 
bankers  themselves  may  buy  and  hold  the  stock  of  the  corpora- 
tion on  account  of  the  confidence  in  their  ability  to  build  its 
future.  The  obviously  poor  appearance  of  its  statements  might 
even  under  such  conditions  have  the  effect  of  scaring  small  or  weak 
holders  into  selling  out,  thus  bringing  liquidations  at  prices  where 
it  is  being  purchased  by  strong  and  friendly  interests,  who  are 
giving  the  needed  support.  This  was  somewhat  the  situation 
in  American  Linseed  in  1914,  but  such  occurrences  are  rare  and 
such  stocks  under  normal  conditions  are  not  attractive. 


In  dividual  Factors  19 

Reorganized  Companies  Attractive 

The  stock  of  a  reorganized  corporation  is  usually  a  good 
speculation.  In  the  first  place,  such  reorganization  generally 
comes  in  times  of  depression  when  the  prices  of  all  securities  are 
near  bottom.  Secondly,  a  reorganization  is  carried  through  by  men  * 
who  are  strong  financially.  In  fact  it  is  just  that  fact  of  financial 
strength  that  put  them  in  charge  of  the  company's  affairs  when 
the  weaker  and  less  competent  management  broke  down. 

Nevertheless,  it  is  a  fact  that  many,  if  not  most,  speculators 
avoid  such  stocks.  The  fact  that  the  company  has  failed  seems 
to  have  greater  weight  than  the  fact  that  new  and  undoubtedly 
strong  financial  interests  have  entered  the  management.  When 
we  recollect  that  management  is  a  primary  factor  in  industrial 
enterprise,  particularly  when  linked  up  with  strong  finances,  the 
mistake  of  looking  back  rather  than  into  the  future  is  apparent. 
In  reorganization,  the  old  debts  are  ordinarily  wiped  out  or  at 
least  eliminated  as  a  fixed  charge,  thus  reducing  the  charges 
ahead  of  the  new  stock  even  though  it  may  be  issued  in  greater 
amount  than  the  original  stock.  Furthermore,  as  the  old  holders 
of  the  indebtedness  become  stockholders  of  the  new  corporation 
their  interests  become  identical  with  the  interests  of  all  other 
stockholders. 

New  Enterprises 

From  the  standpoint  of  either  speculation  or  investmenl  the 
of  new  companies  are  rarely  successful.   It  is  necessary 
thai   pioneering  be  done.     Those  who  do  il  contribute  to  the 
world's  pn  igri  1 1  i-  .1  -.nl  fad  thai  they  rarely  realize  a  profil 

from  their  ventures.  Even  in  the  cases  in  which  n<-w  firms  are 
su<  <  essful  we  can  think  of  fe^  instances  in  which  the  stock  could 
nol  have  been  purchased  below  the  subscription  price  al  some 
9ubsequeni  time. 

This  is  especially  the  case  with   firms  started   in   times  ol 
busine      prosperity.     In  a   boom   period   demand   for  goods  is 
strong,  profits  are  high,  and  there  is  every  inducement  to  under- 
take new  enterprises.     Yel  a  littl<  reflection  will  show  thai  entei 
prises    itarted  al    »uch    times    musl    acquire    their    plants  and 


20  I  n  d  u  s trial  Securities 

purchase'  their  supplies  and  hire  their  labor  at  the  prevailing  high 
prices.  Even  though  the  management  is  honest  and  competent, 
problems  will  arise  and  mistakes  will  be  made.  Then  in  the 
natural  rotation  of  business  cycles,  depression  will  come  with  fall- 
ing prices.  All  these  things  put  a  strain  on  the  new  enterprise,  on 
top  of  which  it  must,  to  be  successful,  pay  a  satisfactory  return 
on  a  capital  investment  made  when  construction  costs,  labor,  and 
materials  were  higher. 

This  has  been  a  prime  difficulty  in  the  way  of  reconstruction 
of  French  industrial  establishments  in  the  devastated  territory. 
To  build  factories  and  equip  them  at  the  high  prices  following  the 
war,  doubtless,  would  have  been  a  charitable  act,  but  it  could 
hardly  have  proven  a  profitable  investment  for  those  who 
furnished  the  money.  The  ability  of  such  establishments  to  earn 
a  decent  return  would  depend  upon  the  indefinite  continuance  of 
high  prices  and  strong  demand.  Every  economist  knew  that  this 
was  impossible,  hence  the  reluctance  on  the  part  of  American 
investors  to  take  hold  of  the  proposition. 

Difficulties  of  Boom  Periods 

The  stocks  of  new  industries  started  in  the  time  of  a  boom  in 
any  particular  line  should  be  particularly  avoided.  Some  years 
ago  there  was  an  epidemic  of  new  rubber  companies.  Naturally 
this  came  on  top  of  the  very  highest  prices  for  rubber  that  have 
ever  been  seen.  More  recently  a  large  flock  of  new  automobile 
companies  were  started.  Some  fell  by  the  wayside  within  a 
short  time.  Others  have  persisted  until  the  present  time  (1920) 
when  they  are  being  forced  out  by  a  falling  off  in  the  demand  for 
motor  cars  and  high  costs  of  production. 

It  is  the  same  with  the  numerous  silver  properties  that  were  so 
widely  advertised  when  silver  was  above  $1.20  per  ounce  or 
more.  Few  silver  mines  started  on  that  boom  can  last  with  the 
price  well  below  a  dollar. 

Besides  all  this  is  the  fact  that  fraud  plays  adisproportionally 
large  part  in  many  such  flotations.  Poor  management,  exorbi- 
tantly large  commissions  paid  to  stock  salesmen  and  retained  by 
promoters,  combined  with  a  desire  to  pay  dividends  quickly  in 


/  n  dividual   Fa  c  t  or  s  21 

order  to  make  the  business  look  attractive,  all  unite  to  make  the 
success  of  these  new  ventures  a  very  remote  possibility  indeed. 
Even  though  the  company  should  prove  one  of  the  rare  exceptions 
that  finally  succeed  there  is  certain  to  be  a  long,  lean  period  in 
which  such  stocks  can  be  purchased  far  below  subscription  price. 

Location  of  Prime  Importance 

The  location  of  a  manufacturing  enterprise,  in  relation  to  its 
markets,  freight  charges,  sources  of  raw  materials  and  its  labor 
supply,  is  a  matter  that  is  many  times  not  sufficiently  considered 
when  business  is  good.  High  prices  may  cover  deficiencies  in 
these  respects,  but  when  prices  slide  off  and  goods  are  hard  to 
sell  keen  competition  is  bound  to  result.  Then  an  apparently 
small  matter  like  a  disadvantage  in  freight  costs  for  materials 
coming  in,  or  finished  product  going  out,  may  readily  assume  a 
fatal  importance.  With  the  speculation  now  going  on  in  our 
industrial  life  the  factor  of  location  is  becoming  of  prime  impor- 
tance. With  declining  commodity  prices  the  slight  attention 
that  has  been  paid  to  this  situation  in  many  cases  is  bound  to 
prove  costly. 

Ownership  of  Raw  Materials 

I  o  own  its  own  sources  of  raw  material  is  an  important  assel 
in  times  of  prosperity  or  advancing  prices.  Then  the  prices  of 
raw  materials  are  high  and  deliveries  poor.  The  company  thai 
owns  its  own  mad -rials  can  be  sure  of  getting  what  it  wants  when 
it  want  -  it .  In  dull  times  or  in  periods  of  falling  prices,  many  times 
it  pays  better  to  buy  raw  materials  Mian  to  produce  them. 

In  mosl  cases  a  policy  of  wise  buyinj  based  on  an  understand- 
ing <>f  fundamental  conditions  and  business  cycles,  togel  her  with 
a  policy  thai  looks  to  the  maintenance  of  financial  strength,  will 
omplish  all  thai  can  I"-  accompli  hed  by  producing  one's  own 
r.iw  materials,  and  with  much  less  investment.  I  here  are  excep 
tions  t<»  this  rule  Doubtless  the  •  .  S.  Steel  Corporation  could 
never  have  grown  and  expanded  as  il  ha  withoul  controlling  it-. 
own  sources  of  raw  materials,  bul  thi  fad  will  generally  be 
found  to  hold  for  the  average  manufai  turing  and  men  handisit 
c<  >n<  ern. 


CHAPTER  IV 

ADVANTAGES  AND  DISADVANTAGES  OF  INDUSTRIAL 

SECURITIES    FROM    THE   STANDPOINT   OF   THE 

TRADER   OR   SPECULATOR 

Position  of  the  Speculator 

The  speculator  or  trader  is  not  primarily  interested  in  security 
and  income.  He  buys  and  sells  stocks  or  commodities  for  the 
purpose  of  making  a  profit  from  changes  in  value.  He  is  engaged, 
therefore,  in  discounting  the  future;  he  is  interested  in  the  finan- 
cial condition,  earnings,  etc.,  of  a  company,  not  in  order  to  see  if 
the  company  is  sufficiently  solid  and  reliable  for  investment,  but 
solely  with  a  view  to  forming  a  judgment  as  to  the  future  trend 
of  the  profits. 

He  will  properly  buy  a  stock  that  has  very  little  present 
value  if  he  thinks  he  has  reason  to  believe  its  value  will  grow  and, 
as  a  result,  its  price  rise.  If  the  prospects  of  a  company  seem 
poor,  the  indebtedness  heavy  and  the  earnings  falling,  these  facts 
would  naturally  deter  the  investor  from  having  anything  to  do 
with  its  securities.  The  very  same  facts  might  well  recommend 
the  stock  to  the  trader  or  speculator  as  a  good  short-sale. 

Greater  Risk  —  Greater  Profit 

Since  the  speculator  wins  or  loses  then  on  changes  in  value,  he 
prefers  industrial  securities  to  rails  because  they  fluctuate  more. 
The  railroad  business  has  become  so  standardized  and  regulated 
that  it  is  no  longer  subject  to  the  fluctuations  or  the  manipulations 
that  characterized  what  we  may  call  the  romantic  period  of 
railroad  history.  In  the  days  when  the  railroads  were  being 
constructed  and  linked  up  all  over  the  country  they  occupied 
much  the  same  position,  marketwise,  as  the  great  industrial 
corporations  have  for  the  past  ten  years. 


Standpoint   of   Trader   or   Speculator    23 

It  has  not  as  yet  proven  practicable  to  standardize  and  reduce 
to  routine  most  manufacturing  and  merchandising  processes,  as 
has  been  done  with  the  public  utility  lines.  Hence,  the  industrial 
lines  are  still  in  a  dynamic  condition.  It  is  in  this  field  that  the 
business  enterpriser  finds  his  opportunity  to  build  and  expand 
and  improve.  In  many  lines  the  technical  processes  are  as  yet 
unsettled,  changes  and  improvements  in  the  machinery  or  pro- 
cesses of  production  are  frequent  and  sometimes  of  the  greatest 
importance.  In  the  field  of  public  utilities  and  railways,  public 
commissions  act  in  one  way  or  another  to  limit  profits,  but  in  the 
industrial  field  the  opportunities  are  far  wider  in  spite  of  the 
excess  profits  tax.  Hence  it  is  in  mainly  the  industrial  field 
that  the  progressive,  ambitious  enterpriser  finds  the  opportunity 
to  create  and  achieve. 


Profit  Factors 

Three  factors  are  involved  in  the  rise  and  fall  of  the  values  of 
securities.  The  technical  position  of  the  market  is  the  dominant 
influence  in  the  day-to-day  or  week-to-week  fluctuations.  It  is 
influential  above  all  in  determining  the  time  when  market  move- 
ments begin  or  end,  although  the  real  causes  of  the  movemenl 
may  be  much  deeper. 

By  the  technical  position  is  meant  the  financial  strength  or 
weakness  of  the  persons  in  whose  hands  the  title  to  securities 
When  are   held   by  large,  wealthy  holders,  who 

control  the  credil  situation  through  their  ownership  in  banks, 
the  technical  position  is  said  to  be  strong.  Hut  the  technical 
position  is  weak  when  .1  large  amount  of  stock  is  scattered  among 
many  holders  of  moderate  means,  most  ol  whom  own  only 
mai  >i"  equities  in  their  holdings  and  are  dependenl  on  the 

bank    for  1  he  monej   to  <  irry  t  hem. 

Tin-  3econd  influence  on  the  price  of  securities  is  the  money 
rate  It  the  currenl  intere  1  rate  rises  this  tends  to  depreciate 
the  price  of  securities,  first,  because  .1  bond  or  preferred  stock 
thai  yields  .1  fixed  return  becomes  less  de  irable,  since  the  same 
amount  oi  return  ran  be  obtained  with  less  capital  than  when  the 


24  In  (I  it  s  trial  Securities 

interest  rati'  was  lower;  secondly,  because  rising  interest  rates 
cut  down  the  profits  of  all  lines  of  business  in  which  interest  is 
an  item  of  expense  in  doing  business. 

Since  the  returns  on  bonds  and  preferred  stocks  are  fixed, 
and  are  (unless  preferred  dividends  are  not  being  earned  and  paid) 
only  remotely  dependent  on  profits,  it  follows  that  if  one  wishes 
to  speculate  on  this  one  factor  alone  he  would  best  confine 
himself  to  bonds  and  preferred  stocks. 

Fluctuations  in  Profits 

But  the  great  underlying  cause  for  the  fluctuations  in  price  of 
common  stocks  is  fluctuation  or  rather  prospective  anticipated 
fluctuation  in  profits. 

Profits  depend  on  the  difference  betwreen  selling  price  and 
costs  of  production.  They  are,  therefore,  increased  by  anything 
which  tends  to  widen  that  spread,  and  diminished  by  whatever 
tends  to  cause  it  to  shrink.  It  is  well  known  that  when  prices 
rise  or  fall,  the  prices  of  all  commodities  do  not  move  together. 
The  lines  which  rise  first  become  very  profitable  because  the  rising 
price  of  the  product  is  not,  at  first,  offset  by  rising  costs  of  pro- 
duction. Wages  are  the  chief  single  element  in  most  production 
costs  and  a  rise  in  wages  always  lags  behind  a  rise  in  commodity 
prices.  Interest  rates  too,  lag  behind  prices.  Hence  a  period  of 
rising  commodity  prices  means  a  period  of  extraordinary  profit 
for  industrial  and  mining  concerns  except  gold  mining. 

Railroads  and  public  utilities,  on  the  other  hand,  having  the 
selling  price  of  their  product  fixed  by  public  authority,  derive 
little  or  no  benefit  from  a  rise  in  prices.  As  the  rise  in  com- 
modity price  spreads  out  into  all  lines  wages  must  be  advanced, 
because  the  demand  for  goods  has  stimulated  production  and 
there  is  a  keen  demand  for  labor  in  all  lines.  Also  as  the  laboring 
class  encounter  the  rising  costs  of  living  they  gradually  come  to 
realize  that  real  wages,  as  measured  in  purchasing  power  rather 
than  merely  in  dollars,  have  actually  declined  and  they  clamor 
for  an  advance  to  correspond  with  the  rise  in  living  costs. 

By  the  time  this  situation  develops  the  price  rise  is  nearing 


Standpoint  of  Trader  or  Speculator   25 

its  peak.  As  prices  cease  to  advance  and  costs  mount,  profits  are 
curtailed.  Meanwhile  common  stocks  in  industrial  and  mining 
corporations  which  represent  a  right  to  share  in  the  profits  have 
advanced  on  the  expectation  of  large  profits.  But  when  prices 
cease  to  rise  and  wages  and  interest  continue  to  mount  these 
expected  profits  fail  to  materialize,  and  a  decline  in  stock  prices 
follows.  The  next  move  is  pretty  sure  to  be  a  fall  in  commodity 
prices  which  wipes  out  profits  in  many  cases  and  produces  a  crop 
of  failures.  This  was  the  situation  that  developed  with  intensity 
in  1920.  And  it  is  upon  industrial  stocks  that  the  weight  of 
these  changing  conditions  falls  most  heavily.  Hence  the  wider 
range  of  their  fluctuations  as  compared  with  other  securities. 

The  stocks  of  railroads  and  public  utilities,  the  prices  of  whose 
products  are  controlled  by  law,  are  affected  in  a  manner  nearly 
opposite.  It  is  only  toward  the  close  of  a  period  of  advancing 
prices  that  public  utilities  or  railroads  are  allowed  to  advance 
their  rates.  Rising  prices  mean  rising  costs  for  them  —  rising 
costs  of  material  and  labor.  There  is  some  offset  in  the  fart  thai 
in  a  time  of  industrial  prosperity  the  demand  for  their  products 
increases  and  the  railroads  carry  more  freight  and  more  passen- 
rs  and  the  electric  lighting  company  sells  somewhat  more 
electricity.  But  this  offset  is  not  nearly  enough  to  compensate 
for  the  rising  co-is  of  production.     On   the  other  hand  when 

material-  and  labor  fall  in  price  the  public  utility  doe-  nol  drop 
ii  -  rate-  until  forced  to  do  so.  It  thus  benefits  by  the  conditions 
which  spell  adversity  to  the  industrial  corporation.  This  is 
why  People's  Gas  and  Hudson  and  Manhattan  Adjustment 
Income  5'a  rose  to  new  high  levels  in  1921  while  industrials,  as 
a  rule,  did  lit  tie. 

Growth  an  All-important  Factor 

The  prospecl  of  growth  is  import. mi  from  the  speculator's 
position.  This  in<  ludes  the  pro  pet  I  for  growth  ol  the  business 
in  general  in  which  the  firm  in  question  is  enj  aj  i  I  and  also  the 
pro-peet  3  of  the  particular  firm  in  question.      \  bu  im      thai  ha 

it   future  prospei  I  .    u<  h  a     I  hi    electrical  bu  ine    .  or  the 


26  /  ;/  (I  it  s  trial   Securities 

exploitation  of  corn  products,  or  the  self-service  stores,  makes  a 
more  satisfactory  purchase  from  the  speculative  standpoint  than 
one  that  has  reached  or  nearly  reached  the  point  of  saturation 
and  is  becoming  stabilized. 

A  corporation  is  a  legal  person,  but  is  supposed  to  differ  from  a 
natural  person  in  being  exempt  from  old  age  and  death.  But 
business  firms  and  corporations  are  not  as  immortal  in  fact  as  in 
theory.  Usually  a  corporation  is  started  by  ambitious  men, 
comparatively  young.  It  has  its  period  of  youth,  growth  and 
construction.  Both  the  founders  and  the  chief  employes  grow 
old,  traditions  are  created  which  act  as  obstacles  to  progress. 

Starting  with  or  acquiring  early,  new  methods  and  new 
equipment,  a  corporation  that  lias  been  in  existence  a  long  time  is 
likely  to  be  loaded  up  with  old  equipment  and  old  ideas.  "Favor- 
ite sons"  creep  in,  holding  positions  and  receiving  pay  that  is 
not  justified  by  their  real  competitive  value.  As  a  result  of  these 
various  influences  there  is  a  tendency  toward  the  same  course  of 
life  among  corporations  that  we  recognize  among  natural  persons; 
birth  —  infancy  —  youth  —  manhood  —  mature  middle  age  — 
ultra-conservative  old  eige,  and  death.  New  firms  are  always 
crowding  to  the  front  supplementing  old  ones  that  fail,  or  are 
reorganized  or  incorporated  in  new  ones. 

A  Virile  Organization  Necessary 

It  naturally  follows  that  the  common  stocks  of  a  young  and 
vigorous  corporation,  not  a  new  one,  are  to  be  preferred  to  those 
of  one  that  has  —  as  we  may  say  -  -  turned  the  corner  of  middle 
life.  Mortality  among  human  beings  is  greatest  in  the  early 
years  of  infancy,  and  as  a  man  grows  toward  maturity  he  becomes 
a  better  insurance  risk.  The  same  is  true  of  corporations.  The 
great  majority  of  new  promotions  fail  within  two  or  three  years 
of  their  inception.  Likewise  many  of  the  very  old  and  long- 
established  corporations  are  likely  to  be  poorer  risks  than  one 
that  is  younger  and  more  vigorous. 

From  the  speculative  standpoint,  the  firm  that  has  passed 
through  the  early  years  of  trial  and  mistakes,  has  gotten  a  firm 


Standpoint   of   Trader   or   Speculator    27 

grip  on  life,  but  is  yet  young,  vigorous  and  growing,  offers  by  far 
the  best  speculative  possibility.  The  analogy  may  appear  fanci- 
ful but  there  is  enough  truth  in  it  to  be  useful.  The  common 
impression  is  that  the  old,  long-established  firm  is  the  more  sub- 
stantial and  the  most  capable  of  weathering  a  storm.  Yet 
that  this  is  not  so  is  nowhere  better  illustrated  than  by  the 
recent  difficulties  of  that  old  stable  industrial  security  — 
American  Sugar  Common.  To  a  certain  extent  this  is  true  as 
regards  the  protected  investment  securities  of  the  firm,  but 
even  from  the  investment  standpoint  there  is  a  limit  beyond 
which  this  does  not  hold. 

Furthermore,  the  speculator  must  always  bear  in  mind  that 
stocks  were  made  to  sell.  When  a  corporation  is  young  and 
vigorous,  when  it  is  growing  rather  than  made,  the  large  owners 
of  the  stock  are  directing  a  large  part  if  not  all  their  energies  to 
building  up  the  enterprise.  When  the  company  is  successfully, 
or  apparently,  permanently  established  and  good  dividends  arc 
being  paid,  the  old  owners  see  a  good  profit  on  their  stock  holdings. 
These  large  profits  available  tempt  the  owners  to  sell  or  distribute 
to  the  public  a  large  portion  of  their  holdings.  It  is  sad  bul  true 
—  in  fact  simply  human  nature  —  that  under  such  developments 
the  vigor,  initiative  and  strength  in  the  managemenl  is  apt  to 
decline,  with  the  result  that' often  dry-rot,  or  as  we  ha\  e  termed 
it — corporate  old  age  creepsin.  This  development,  il  can  be 
readily  seen,  does  nol  augur  well  for  the  large  body  of  scattered 
stockholdi 


-  .j  - 


CHAPTER  V 

ADVANTAGES  AND  DISADVANTAGES  OF  INDUSTRIAL 
SECURITIES  AS   INVESTMENTS 

Position  of  Common  Stockholder 

The  prime  requisite  for  an  investment  is  security.  In  this 
respect  the  securities  of  industrial  corporations  differ  very  widely. 
Common  stock  represents  the  share  in  an  equity,  in  the  profit 
and  risks  of  a  going  business  after  all  fixed  charges,  labor,  mate- 
rials, etc.,  have  been  met.  If  a  man  buys  a  controlling  share  or 
even  a  very  large  proportion  of  the  stock  in  an  industrial  corpo- 
ration he  acquires  thereby  a  powerful  influence  in  the  conduct  of 
business.  That  is  to  say,  he  engages  in  business  enterprise,  and 
has  in  that  sense  invested,  yet  that  use  of  his  money  should  not 
be  regarded  as  an  investment  in  the  technical  sense. 

The  man  is  not  properly  an  investor,  but  a  business  enter- 
priser. If,  however,  he  buys  only  a  few  shares  in  a  large  corpo- 
ration, whatever  his  legal  or  technical  rights  as  stockholder, 
he  has  virtually  no  control  whatever  over  the  management 
of  his  capital.  The  commitment  is  for  him  a  speculation 
based  on  his  judgment  of  business  conditions  in  general,  and  as 
regards  that  business  in  particular,  and  also  on  the  ability,  judg- 
ment and  honesty  of  the  men  who  are  managing  that  business. 
He  has  no  protection  against  business  losses  due  to  failures  or 
mistakes  in  any  of  these  factors. 

Position  of  Bondholder 

If  one  purchases  bonds  in  industrial  corporations,  the  case  is 
quite  different.  A  bond  being  a  promise  to  pay  a  stipulated 
sum  at  a  definite  time  with  interest  is  a  debt  of  the  corporation 
and  a  lien  on  all  its  earnings  and  assets.     If  the  amount  of  bonds 


Industrial   Securities  as   Investments  29 

and  notes  outstanding  is  small  in  relation  to  the  total  capital,  if 
the  business  has  shown  stability  of  earnings  over  a  considerable 
period  of  time,  if  the  demand  for  the  products  is  reasonably 
certain  and  the  management  competent  and  efficient,  such  a 
bond  may  constitute  a  high-grade  investment. 

If  the  earnings  over  a  ten-year  period  have  been,  in  the  poorest 
year,  at  least  two  and  a  half  times  the  amount  necessary  to 
provide  for  interest  and  sinking  fund  on  the  bonds  and  the  total 
assets  at  least  twice  the  total  of  outstanding  bonds  this  should 
be  sufficient  to  insure  safety. 

Stability  of  Demand  and  Diversification 

A  powerful  factor  contributing  toward  the  stability  of  an 
industrial  enterprise  is  that  its  products  be  such  as  are  in  steady 
and  constant  demand.  The  5-  and  10-cent  stores  furnish  a  line  of 
goods  that  the  mass  of  the  people  will  always  buy.  Periods  oi 
prosperity  and  depression  make  comparatively  little  difference 
in  the  earnings.  The  same  is  generally  true  of  concerns  manu- 
facturing or  marketing  standard  food  products  or  oilier  neo 
sarie-.  Ai  the  other  extreme  are  such  "feast  or  famine"  industries 
as  t  In-  steel  busint ;ss  or  the  manufacl  ure  of  motor  cars.  In  times 
of  prosperity,  the  steel  business  booms  and  in  periods  oi  depn 
-ion,  the  earnings  may  drop  very  low.  The  I'.  S.  Steel  Corpo- 
ration has  followed  a  safe  and  conservative  policy  by  paying  oul 
much  less  than  was  earned  in  boom  periods  and  accumulating  a 
reserve  to  maintain  dividends  when  the  tide  went  out. 
This  has  served  to  secure  a  stability  thai  would  otherwise  have 

■i  lacking. 

A  corporal  ion  thai  makes  agreal  number  oi  allied  products  is 
likely  to  have  a  more  3table  business  than  one  thai  makes  one 
thing  alone.  A  manufacturing  concern  thai  makes  only  silvei 
ware,  for  example,  is  ai  the  mercy  of  conditions  affecting  the 
silver  markel  and  the  demand  for  silverware.  Bui  the  earnings 
..i  the  1  ,  S.  Rubber  Company  are  contributed  to  b)  everj  imagi- 
nable article  of  rubber  from  tin     to  toysand  from  rubbei  i  lothi 

lo    hie    !,.  | 


30  Industrial     Securities 

Character  of  Demand 

Other  things  being  equal,  the  bonds  or  stocks  of  a  large  corpo- 
ration with  a  nation-wide  market  are  safer  than  those  of  asmaller, 
more  local  enterprise.  Prosperity  and  depression  do  not  affect 
all  parts  of  the  country  to  the  same  degree.  Business  will  usually 
remain  good  throughout  the  agricultural  regions  of  the  West  when 
New  York  and  New  England  are  in  the  depths  of  depression. 
By  the  time  the  depression  hits  the  West  the  South  may  still 
show  a  fairly  good  demand,  and  when  that  fails  business  in  the 
Northeastern  states  is  likely  to  show  an  improvement.  It  is, 
therefore,  possible  to  curtail  or  suspend  production  in  some  of  the 
company's  plants  and  concentrate  production  or  sales  in  those 
territories  that  show  the  best  demand. 


Prospects  of  Growth 

It  is  desirable,  but  not  necessary,  from  a  purely  investment 
standpoint,  that  the  business  be  one  with  good  prospects  of 
growth.  Such  was  the  steel  business  twenty  or  even  ten  years 
ago.  Today,  its  prospects  for  further  growth  are  not  nearly  so 
good.  The  economies  of  large-scale  production  have  been 
achieved;  the  uses  for  steel  products  have  been  fully  developed, 
and  it  is  hardly  possible  that  the  growth  of  this  industry  in  the 
next  ten  years  will  begin  to  compare  with  that  of  the  past  ten. 
An  industrial  like  Corn  Products,  on  the  other  hand,  has  excellent 
possibilities  for  growth.  The  question  of  growth,  however,  is 
far  more  important  from  the  standpoint  of  speculation  than  from 
the  investment  angle,  and  was,  therefore,  dealt  with  fully  when 
we  considered  industrial  securities  from  the  speculative  point  of 
view. 

Preferred  Stocks 

The  revenue  laws  which  allow  the  money  obtained  from  the 
sale  of  preferred  stock  to  be  treated  as  "invested  capital"  whereas 
capital  represented  by  bonds  cannot  be  so  counted,  has  given  a 
great  impetus  to  the  issue  of  preferred  stocks  in  circumstances 


Industrial  Securities   as  Investments  31 

where,  before  the  war,  an  industrial  corporation  would  have 
issued  bonds.  In  form,  a  preferred  stock  is  just  like  a  common 
share,  except  that  the  prescribed  rate  of  dividend  upon  the 
preferred  must  be  paid  before  any  earnings  can  be  distributed  to 
the  common  stockholders.  In  the  event  of  liquidation,  the 
preferred  shares  are  ordinarily  preferred  as  to  assets. 

An  investor  need  not  be  afraid  of  the  word  "stock,"  provided 
the  same  tests  are  applied  to  the  corporation  as  to  stability  of 
earnings,  demand  for  product,  and  proportion  of  preferred  stock 
to  total  capital  that  wire  laid  down  for  testing  the  security  of 
bonds.  In  addition,  the  investor  must  make  sure  that  either 
no  bonds  are  outstanding  ahead  of  the  preferred  stock,  or  that 
the  quantity  of  such  bonds  added  to  the  amount  of  preferred 
stock  is  still  within  the  bounds  of  safety. 

In  the  case  of  either  bonds  or  preferred  stocks  it  is  necessary 
to  see  that  no  other  issues  of  bonds  or  preferred  stock  can  be  put 
ahead  of  the  outstanding  or  proposed  issues  without  the  consenl 
of  the  holders  of  those  securities.  In  the  case  of  preferred  stock, 
the  dn  idends  must  be  cumulative;  otherwise,  it  will  be  possible 
for  common  stockholders  who  control  the  management,  to  pass 
all  dn  idends  on  both  common  and  preferred,  putting  all  earnings 
back  into  property,  building  up  equity  values  thai  ultimately 
go  to  the  con  in  ion  stockholders.  While  the  security  behind  both 
bonds  and  preferred  stock  would  be  strengthened  by  such  a  pro- 
cedure, the  preferred  stockholders  would  be  deprived  oi  .ill 
return  on  their  money  during  the  process. 

Another  feature  of  the  presenl  revenue  laws  (1920)  that  makes 
preferred  stocks  attractive  is  the  exemption  from  the  normal 
I  ederal  income  tax  which  is  granted  the  dividends  on  all  stocks 
of  domestic  corporations.  States  which,  like  Mas  a<  husetts  or 
Ohio  have  a  State  income  tax,  also  granl  exemption  to  the  divi- 
dends oi  .ill  corporations  of  thai  State  which  pay  income  Lax  to 
the  State.  This  makes  .1  good  Massachusetts  or  Ohio  indu  trial 
preferred  stock  .1  de  irable  in  1  itmenl  foi  a  1  itizen  ol  thai  State 

ce  his  dividend    are  exempl  from  both  State  income  tax  and 
from  the  ni 'Nii.il  Federal  tax. 


CHAPTER  VI 
THE   BALANCE   SHEET 

Difficulties  in  Studying 

Practically  all  industrial  corporations  now  issue  statements, 
or  balance  sheets,  to  show  their  financial  condition,  at  least 
annually. 

Every  investor  who  owns  or  who  contemplates  buying  any  in- 
dustrial securities  should  certainly  take  the  trouble  to  look  over 
the  annual  statements  of  the  corporation  in  which  he  is  interested. 
They  arc  equally  important  for  the  long-swing  speculator.  It 
does  little  good  to  look  at  one  statement.  A  series  of  statements 
should  be  used  and  a  sufficient  series  to  cover  normal,  subnormal 
and  prosperity  conditions.  For  example,  it  might  do  more  harm 
than  good,  in  considering  the  future  prospects  of  a  corporation, 
simply  to  study  its  balance  sheet  for  December  31st,  1918,  and 
1919.  The  balance  sheet  for  December  31st,  1920,  following  a 
year  of  deflation,  would  be  quite  apt  to  show  a  materially  different 
condition. 

It  is  also  true  that  industrial  statements  sometimes  are 
notable  for  their  lack  of  information  rather  than  for  their  wealth 
of  information.  Many  of  them  often  omit  much  information 
that  is  decidedly  important.  It  is  also  possible  to  doctor  state- 
ments in  various  ways.  Moreover,  even  the  certification  of 
a  reputable  accountant  does  not  guarantee  the  appraisal  of 
items  in  the  assets.  Neither  can  it  guarantee  the  accuracy 
of  the  firm's  calculation  as  to  the  amount  of  depreciation  that 
should  be  charged  off,  nor  does  it  ordinarily  guarantee  the  entries 
in  the  corporation's  books  from  which  the  statement  is  made  up. 

Holding  Companies  Particularly  Difficult 

An  industrial  holding  company,  by  its  very  nature,  offers 
many  difficulties  in  analysis.     A  holding  company,  controlling 


The  Bala  nee   Sheet  33 

numerous  subsidiaries  to  which,  at  times,  it  may  lend  monetary- 
assistance  and  from  which  at  all  times  it  receives  dividends,  can, 
it  may  readily  be  seen,  do  much  juggling  between  the  accounts  of 
the  holding  corporation  and  those  of  the  subsidiaries.  As  a 
result,  in  considering  the  condition  of  holding  companies,  a  con- 
solidated statement  must  be  demanded,  that  is,  a  statement  that 
gives  the  combined  conditions  of  all  the  subsidiaries  and  the 
parent  organization. 

If  the  management  of  a  holding  company  wishes  to  make  a 
good  showing  it  is  possible  to  count  as  income  the  dividends  paid 
into  the  treasury  from  successful  subsidiaries  and  omit  the  losses- 
of  the  unsuccessful.  In  other  words,  if  the  parent  organization 
depends  for  its  income  on  the  dividends  of  the  stocks  of  subsid- 
iaries that  it  holds,  its  immediate  and  direct  income  would  not  be 
affected  by  losses  which  prevented  the  payment  of  dividends 
except  insofar  as  the  money  received  from  dividends  as  a  whole 
declined.  A  holding  company  can  lend  money  to  an  unsound 
subsidiary  and  count  the  subsidiary's  notes  among  its  own  assets. 
We  think  there  is  no  point  that  shows  more  clearly  the  necessity 
of  considering  the  subsidiary  statements  as  well  as  the  statement 
of  the  parent  organization  than  this  one. 

On  the  other  hand,  when  the  subsidiaries  of  a  holding  com- 
pany are  making  large  profits,  it  is  possible  of  course,  for  them  to 
declare  very  small  di\  idends  and  put  the  surplus  into  resen  e  or 
plant  construction  account.  Under  such  conditions,  the  state- 
ment of  the  holding  company,  the  parent  organization,  would 
appear  very  poor  as  its  income  would  be  small.  As  a  result, 
owners  of  the  holding  company  securities  would  be  apl  to  liqui- 
date their  se<  urities,  if  they  simply  looked  al  thai  condition  and 
did  not  take  into  consideration  what  the  subsidiaries  were  doing 
in  t  heir  own  organizal  ion 

The   Use  of  Statements 

It  is,  of  course,  always  possible,  as  we  have    tated  above,  for 
any  corporation,  holding  or  operating,  to  cover  u  pa    el    or,  on  the 

other  hand,  to  waste  them.     It  is  difficull   to  dete<  i  a  condition 


34  /  ;/  d  a  s  t  r  i  a  I  S e  curities 

under  which  items  are  charged  to  expense,  which  should  be 
charged  to  capital  account  and  as  a  result,  earnings  are  cut  down. 
It  is  equally  difficult  to  determine  from  the  balance  sheet  whether 
the  charges  against  capital  account  were  conservative  or  whether 
a  portion  should  have  been  charged  to  expenses.  It  is,  therefore, 
possible  for  an  industrial  corporation  to  make  a  statement  which 
reflects  the  value  of  its  assets  to  a  much  less  degree  than  it  should, 
while  it  is  equally  possible  to  render  a  statement,  satisfactory  on 
its  face,  which  gives  assets  a  relatively  inflated  value. 

One  might  feel,  up  to  this  point,  that  there  was  little  use  in 
considering  industrial  balance  sheets.  This  is  not  so.  By  using 
a  little  care  and  taking  a  series  of  from  three  to  four  statements,  an 
intelligent  idea  of  the  progress  or  lack  of  progress  of  a  corporation 
may  be  obtained.  That  is  to  say,  it  is  possible  to  tell  whether  a 
company  is  growing  stronger  or  weaker,  whether  the  equity 
belonging  to  the  stockholders  is  growing  or  declining,  and 
whether  the  business  prospects  of  the  company  are  improving  or 
getting  poorer. 

The  Typical  Balance  Sheet 

The  typical  statement  appears  in  two-column  form  —  the 
assets  on  one  side  and  liabilities  on  the  other.  This  distinction  is 
easy  to  grasp  if  we  bear  in  mind  that  any  item  on  which  the 
corporation  could  realize,  if  it  were  to  liquidate  and  go  out  of 
business  tomorrow,  is  an  asset.  On  the  other  hand,  any  item  is  a 
liability  if  it  is  something  that  the  corporation  would  have  to  pay 
out  if  it  were  to  liquidate  tomorrow.  This  principle,  of  course, 
does  not  apply  to  the  value  of  the  respective  assets  or  liabilities. 
For  example,  if  a  company  were  to  liquidate,  it  is  quite  apparent 
that  some  assets  would  have  greater  immediate  value  than  others. 
A  manufacturing  plant  is  obviously  of  more  value  as  a  going 
concern,  that  is  using  it  to  produce  goods,  than  it  could  possibly 
be  if  offered  to  anyone  else.  The  same  is  true  of  goods  in  process 
of  manufacture  that  are  being  made  for  a  definite  purpose.  It  is 
unnecessary  to  point  out  that  such  assets  as  trucks,  office  supplies, 
patterns,  dies,  patents,  trade  marks  and  good-will  have  question- 
able value  under  liquidation. 


The  Balance   Sheet  35 

The  Assets  Side 

The  items  ordinarily  listed  on  the  assets  side  of  an  industrial 
balance  sheet  are  as  follows: 

Capital  Assets 

Plant  and  property 

Treasury  stock  and  bonds 

Patents 

Trade  marks 

Good-will 

Investments 

Current  Assets 

Cash 

Inventories  (materials  and  supplies,  or  stock  in  trade) 

Goods  in  process  of  manufacture 

Accounts  receivable 

Accrued  interest  on  accounts  receivable 

I  >rafts  and  notes  receivable 

Accrued  interest  on  drafts  and  notes  receivable 

Accrued  interesl  on  bonds  owned 

Due  from  subscribers  to  capital  stock 

Dividends  declared  on  stock  owned 

( >ther  As 

Insurance  fund 
Pension  fund 
I  deferred  assel  s 

unetimes  inventories  are  listed   separately  as  working  or 
tradinj  ts.     This  is  nol   usual,  however.     They  are  placed 

under  (  urrent  .  in    pite  of  the  fat  i  that  their  value  probably 

fluctuates  more  than  any  other  item  in  the<  urrenl  as  sel    account. 
Inventories  in  the  lasl  i<  v  .  with  the  inflation  and  deflation 

thai  has  prevailed,  have  ilu«  tuated  to  an  extraordinary  degree, 
first  in'  re  i  ing  rapidly  and  i  hen  de<  linii 


36  I n  d  it  s trial    Securities 

The  Liabilities  Side 

The  items  under  the  head  of  liabilities  are: 

Capital  Liabilities 

Common  stock  issued  and  outstanding 
Preferred  stock  issued  and  outstanding 
Bonds  issued  and  outstanding 
Notes  issued  and  outstanding 

Current  Liabilities 

Taxes  accrued 

Payroll  accrued 

Expenses  accrued  (rent,  lighting,  etc.) 

Notes  and  drafts  payable 

Interest  on  notes  and  drafts  payable 

Interest  accrued  on  bonds  and  notes 

Dividends  payable 

Other  Liabilities 

Reserves 
Capital  surplus 
Undivided  profits 

These  items  appearing  on  either  side  of  the  balance  sheet  must 
be  supported,  in  the  corporation's  income  tax  report,  by  schedules 
showing  details  which  go  to  make  up  the  various  items,  but  such 
information  is  not  usually  available  to  the  ordinary  speculator  or 
investor. 

The  Individual  Items 

Assuming  that  we  are  in  possession  of  several  consecutive 
balance  sheets,  let  us  briefly  examine  the  important  items  on 
these  balance  sheets. 

First,  plant  and  property.  —  Two  policies  are  possible  with 
regard   to  these  items.     As  we   all    know,    physical    equipment 


The  Balance   Sheet  37 

which  can  be  put  under  this  head,  with  the  exception  of  land,  will, 
in  spite  of  all  reasonable  upkeep,  deteriorate  in  time.  A  manu- 
facturing plant  deteriorates  relatively  quickly,  at  a  rate  estimated 
to  be  at  from  10%  to  25%  a  year,  depending  on  the  character  of 
the  plant.  Conservative  balance  sheets  should  show  this  factor, 
either  by  constantly  writing  off  a  certain  percentage  of  the  value 
year  by  year,  thus  giving  the  plant  and  property  a  proportion- 
al i-ly  lower  value,  or  by  carrying  the  original  value  in  the  assets 
column  and  setting  up  a  depreciation  reserve  on  the  liabilities 
side.     The  latter  is  preferable. 

Vet  it  is  quite  possible,  and  has  happened  many  times  in  the 
prosperity  of  the  past  ten  years,  that  additional  plant  and  equip- 
ment have  been  provided  out  of  earnings.  If,  under  such 
conditions,  the  value  of  the  assets  is  increased,  this  increase 
ould  be  accompanied  by  growth  of  the  item  "surplus"  on  the 
liabilities  side.  A  gradual  reduction  in  the  value  given  plant 
and  property  indicates  conservatism  and  a  desire  to  gradually 
strengthen  the  financial  position.  An  adverse  factor  to  be 
watched  is  that,  the  value  given  the  plant  and  property  may 
remain  unchanged  while  the  reserve  for  depreci.it  ion  is  relatively 
insufficient. 

Patents,  Trade  Marks  and  Good-will 

Patents,  while  undoubtedly  valuable  in  many  cases,  have  only 
,i  limited  period  to  run  and  are  always  in  danger  of  infringement, 
which  is  hard  to  prevent.  Whatever  a  firm  lias  paid  for  its 
patents  musl  be  entered  as  an  asset,  bul  h  should  always  be 
protected  by  an  especially  liberal  depreciation  reserve  on  the 
liabilil  ies  side. 

I  rade  marks  are  valuable  onl)  as  maintained  by  steady  adver- 
tising.    Any  valuation  of  them  should  be  low. 

i  iood-will  is  a  real  assel  in  man}  i  a  e  to  a  going  concern,  bu1 
is  usually  worth  comparatively  little  in  liquidation.  II  the 
valuation  of  this  item  i  I  u  ;e  or  i  in<  reased,  il  would  undoubt- 
edly show  thai  the  managemenl  was  anxious  to  make  a  good 
Bhowing  in  Such,  ol  course,  indicates  weakness.     The 


44  ?472 


38  In  d  u  s  trial   Securities 

strongest  firms  either  try  to  work  off  this  item,  or,  if  maintained 
on  the  books  in  order  to  give  as  large  a  basis  as  possible  for 
figuring  exemption  under  the  excess  profits  tax,  they  set  up 
liberal  reserves  against  it,  wherever  possible. 

Investments 

A  publishing  business,  or  any  similar  business  that  accepts 
payments  in  advance,  must  have  invested  funds  to  cover  the 
amount  of  the  advance.  This  is  necessary  because,  in  event  of 
liquidation,  this  money  would  have  to  be  returned  immediately 
to  the  payers.  Beyond  this,  however,  it  is  not  desirable  that 
a  rapidly  growing  concern,  either  manufacturing  or  mercantile, 
should  have  a  large  amount  of  permanent  investments.  The 
best  that  can  be  said  for  them  is  that  they  improve  the  organ- 
ization's credit.  Its  business,  however,  is  manufacturing  or 
merchandising,  not  investing. 

Furthermore,  unless  the  items  that  go  to  make  up  this  account 
are  available,  the  value  given  it  may  be  illusory.  Investing  is  a 
science.  Even  the  estates  of  wealthy  and  successful  men  show  a 
surprising  number  of  "cats  and  dogs,"  worthless  investments. 
These  invariably  were  investments  made  outside  of  the  lines  in 
which  these  men  were  successful.  It  is  naturally  apt  to  be  the 
same  with  an  organization.  Hence,  as  a  general  rule,  a  firm 
does  best  when  it  invests  its  surplus  in  its  own  business.  Pension 
reserves  or  reserves  to  provide  benefits  to  employes  must  be 
invested  in  outside  securities,  and  these  are  ordinarily  placed  in 
the  safest  securities  obtainable. 

Again,  permanent  investments  are  only  intended  to  be  drawn 
against  in  an  emergency.  In  the  majority  of  cases,  when  the 
emergency  comes,  it  will  be  almost  certain  to  fall  in  a  period  of 
liquidation  or  business  depression,  or  possibly  a  panic.  At  such 
times,  even  the  highest-grade  securities  cannot  be  liquidated 
except  at  a  considerable  discount. 

Current  Assets 

Needless  to  say,   a  good   showing  of  cash   is  desirable.     A 


The  B  alance   Sheet  39 

decrease  in  this  item  means  that  a  concern  is  depending  more  and 
more  on  the  banks  and  is  not  well  trimmed  to  stand  a  storm. 

Inventories  are  taken  either  at  cost,  or  "at  cost  or  market," 
whichever  is  lower.  This  account  should  be  scanned  carefully. 
Over  the  past  few  years,  many  industrial  corporations  have 
allowed  their  inventories  to  increase  tremendously,  and  it  has  not 
been  extraordinary  to  see  an  organization  with  an  inventory 
account  which  equalled  or  exceeded  its  fixed  assets.  I  f  we  are  in  a 
period  of  depression  and  the  earnings  statement  is  satisfactory,  a 
large  inventory  account  is  often  a  strong  feature.  In  a  period  of 
high  prices,  the  reverse  is  true. 

The  large  inventory  accounts  that  the  majority  of  industrial 
organizations  showed  in  their  reports  for  the  year  ended  Decem- 
ber 31st,  1919,  when  prices  were  approximately  the  highest  we 
have  even  known,  proved  to  be  a  source  of  very  great  loss  \\  ithin 
the  next  twelve  months.  Corporations,  like  individuals,  are  apt 
to  purchase  strongly  in  an  advancing  market  and  to  buy  mosl 
heavily  around  the  top.  When  an  organization  can  be  found 
which  shows  a  tendency  to  accumulate  inventories  in  depression 

irs  and  lighten  in  years  of  prosperity,  it  can  be  looked  upon  as 
being  an  extraordinarily  good  risk. 

Goods  in  process  of  manufacture  include  labor,  materials, 
inward  freight,  duties  and  usually  a  portion  of  the  overhead. 
Because  these  values  are  real  to  a  going  concern,  they  may  be 
-lioun  iii  this  way.  They  would,  however,  bring  little  in  liqui- 
dation and  they  should,  as  a  result,  be  protected  l>\  a  good 
reserve.  <  lonsen  ative  firms  carrj  su<  h  items  as  coal,  oil,  garage 
supplies,  stationery,  etc.,  al  a  very  1"\\  value,  often  nearly 
nominal. 

^CCOUHt8   Receivable 

li  .i  busim      i    one  in  whi<  h  it  is  customary  to  extend  trade 

credil   ,    like   the   manufa<  ture   of   agi  i<  ultural    implements,   an 

increa  e  in  notes  and  drafts  receivable  maj    merelj    indicate  a 

larger  volume  ol   3ales.      \\   the  5ame  time,   such  a  business  is 

posed  to  risks  thai  'I"  nol  exisl  with  the  Woolworth   ston 


40  Industrial   Securities 

4 

for  example.  With  a  business  of  the  ordinary  type  a  marked 
increase  in  accounts  receivable  or  notes  receivable  would  ordi- 
narily show  that  collections  are  becoming  increasingly  poor,  as  the 
drafts  or  notes  might  well  be  over-due  accounts. 

Treasury  stock  should  only  be  counted  as  an  asset  when  it 
represents  stock  that  has  been  issued  for  value  and  subsequently 
repurchased  by  the  treasury. 

Fixed  Liabilities 

On  the  liability  side,  the  most  important  items  to  watch  are 
those  which  impose  fixed  charges  that  cannot  be  defaulted  with- 
out incurring  foreclosure  proceedings.  They  are,  therefore,  the 
bonds  and  notes  outstanding,  notes  and  drafts  payable,  taxes 
and  payrolls  accrued.  Dividends,  even  on  cumulative  preferred 
stocks,  can  be  passed  or  deferred.  Stockholders  can  be  told  to 
wait,  but  bonds  and  notes  must  be  met  when  due. 

As  a  result,  an  increase  in  bonds  and  notes  outstanding  in 
proportion  to  the  capital  stock  shows  quite  clearly  that  the 
management  is  slipping.  As  a  matter  of  fact,  in  order  to  show 
progressive  strength,  a  decrease  in  these  items  should  be  seen. 
During  the  past  industrial  prosperity  it  has  been  valuable  to 
note  that  certain  organizations  have  been  gradually  increasing 
their  notes  and  bonds  outstanding,  in  spite  of  a  tremendous 
earning  power.  This  probably  means  that  the  earnings  have 
been  put  back  into  property  in  the  shape  of  fixed  assets.  In  the 
meantime,  the  inventory  account  has  constantly  increased,  thus 
necessitating  a  larger  working  capital.  Inasmuch  as  a  consid- 
erable proportion  of  the  earnings  have  become  fixed  assets,  it  has 
been  necessary  to  borrow  additional  funds  to  replenish  working 
capital. 

Working  Capital 

Working  capital  is  the  difference  between  current  assets  and 
current  liabilities.  This  is  really  the  all-important  item  in  an 
industrial  balance  sheet.  It  is  what  makes  the  mare  go.  In  a 
consideration  of  three,  four  or   five  consecutive  balance  sheets, 


The  Balance   Sheet  41 

the  relative  increase  or  decrease  in  working  capital  should  be 
studied  closely.  A  company  may,  for  example,  show  a  constant 
increase  in  surplus,  and  at  the  same  time,  a  decline  in  working 
capital.  Such  a  condition  might  develop  from  numerous  sources. 
As  vve  have  pointed  out  above,  increasing  the  value  given  to 
plant  and  property  would  be  reflected  on  the  liability  side  in  an 
increase  in  surplus.  Hence,  an  increase  in  surplus  alone  is  of 
little  value.  An  increase  or  decrease  in  working  capital,  however, 
can  only  come  through  an  increase  in  current  assets  or  a  decrease 
in  current  liabilities,  or  on  the  other  hand,  a  decrease  in  current 
assets  or  an  increase  in  current  liabilities.  Therefore,  it  is,  w  e 
believe,  the  most  important  factor  in  the  balance  sheet,  and  if  a 
company  which  is  paying  dividends  shows  a  decrease  in  working 
capital  over  a  number  of  years,  its  securities  should  certainly  be 
avoided. 

Current  Liabilities 

Current  liabilities  need  little  explanation  outside  of  thai  gh  en 
under  the  caption  of  "Working  Capital".  It  goes  w  ithoul  saying 
that  taxes,  payrolls  and  expenses  accrued  should  be  kepi  as  low  as 
possible.  Drafts  and  notes  payable  may  increase  to  finance  an 
increase  in  the  inventory  account  bu1  if  they  increase  without 
any  corresponding  increase  in  current  assets,  thus  decreasing 
working  capital,  we  can  only  repeal  thai  it  is  probably  the  mosl 
dangerous  situation  thai  could  develop.  Interesl  accrued  on 
noic-,  bonds  and  drafts  should,  of  course,  be  taken  care  ol  as 
soon  .1-  possible  and  should  be  kepi  a1  a  low  figure. 

Capital  surplus  and  undivided  profits  should  show  a  constanl 

owth.     It  is  always  necessary,  however,  to  bear  in  mind  thai 

the  surplus  accounl  in  a  balance  3heel  is  the  balance  between 

and   liabilities.     It   shows  simply   hov    mu<  h    th<    a    ets 

I  the  liabilities.     An  in<  rea  <■,  bj  n  ..  li,  is  nol  3uffi<  ienl  to 

be<  ome  enthu  ia  I  u    over.     [1    should   be  detei  mined   w  hel  her 

5u<  h  in'  rea  e  ha    i  ome  from  an  in<  rea  e  in  currenl  a    ets,  wh 

rcil,-,  i  -  an  increase  in  working  capital,  or  a  markinj  up  ol  capital 

or  ol  her  a    ets. 


CHAPTER  VII 
THE   INCOME  ACCOUNT 


Points  to  Get 


As  with  balance  sheets,  there  is  little  use  in  considering  a 
single  annual  income  account.  A  series  of  at  least  three  or  four 
should  be  obtained  to  show  the  progress,  or  lack  of  progress,  of 
the  company.  In  such  a  comparison,  the  following,  we  feel,  are 
the  chief  points  which  should  be  looked  into,  wherever  possible. 

First,  Net  Sales. — This  item  is  not  easy  to  obtain.  The 
primary  item  in  any  income  account  is  variously  put  forward  as 
gross  earnings,  gross  income  and  gross  revenue.  Any  one  of 
these  three  factors  may  comprise  income  of  all  kinds  from  what- 
ever source.  What  the  investor  or  speculator  would  like  to  find 
is,  of  course,  the  revenue  obtained  from  sales  of  the  product  that 
the  company  is  producing.  It  is  for  that  reason  that  net  sales 
become  important.  Gross  income  often  includes  interest  re- 
ceived on  investments,  profits  from  sales  of  real  estate,  or  in  some 
cases,  it  has  been  known  to  contain  merely  estimated  profits 
through  an  advance  in  the  value  of  real  estate  or  other  property 
held  by  the  company.  Furthermore,  in  times  such  as  we  have 
just  been  through,  the  increase  in  the  value  of  inventories  may 
even  be  brought  into  service  and  appear  in  the  gross  income 
account  if  it  is  desired  to  make  a  good  showing. 

Where  the  item  "net  sales"  does  not  appear,  the  entire  income 
account  should  be  scanned  carefully  in  the  attempt  to  determine 
whether  gross  income,  gross  revenues  or  gross  earnings  are 
practically  net  sales,  or  whether  they  include  considerable  income 
from  outside  sources.  When  other  sources  of  income  are  negli- 
gible, gross  revenues  will  be  practically  the  same  as  gross  sales. 
Gross  sales,  in  turn,  will  not  differ  materially  from  net  sales,  if 
returned  goods,  allowances  and  freight  charges  are  very  small, 
which  is  likely  to  be  the  case. 


The   Income   Account  43 

Expenses  of  Doing  Business 

Having  established  as  nearly  as  possible  the  value  of  the  item 
in  the  income  account  showing  the  revenue  received,  our  next  step 
is,  of  course,  to  obtain,  if  possible,  the  cost  of  selling  the  goods. 
Many  times,  this  item  is  not  furnished  directly  because  the  com- 
pany does  not  wish  to  give  out  such  information  which  ii  feels 
might  be  valuable  to  competitors.  In  any  detailed  industrial 
statement,  combining  both  income  account  and  balance  sheet,  if 
we  can  find  the  value  of  the  inventory  item  at  the  beginning  of 
the  year  and  add  to  that  the  factory  costs  for  the  year,  subtract- 
ing from  the  sum  thus  obtained  in\  entories  at  the  end  of  the  year, 
we  should  have  directly  the  cost  of  merchandising.  Such  items 
are  rarely  available,  however. 

The  ordinary  industrial  statement  after  showing  gross  income. 
may  simply  jump  to  gross  profits  from  operations.  The  difference 
between  gross  profits  from  operations  and  gross  earnings  is 
nominally  the  operating  cost.  This  may  or  may  not  include 
depreciation  and  renewals  according  to  the  wishes  of  the  manage- 
ment. Over  a  series  of  years,  however,  some  value  can  be 
obtained  by  comparing  constantly  the  ratio  of  net  profits  to 
gross  earnings,  although  a  change  in  the  accounting  principles 
mu.-t  be  watched  as  it,  of  course,  would  throw  such  deductions 
askew.     Such  changes  are.  however,  quite  apparent. 

Net  profits  are  obtained  by  deducting  administrative  and 
general  expenses  from  gro  profits.  We  again  call  attention  to 
the  value  of  comparing  nel  profits  with  gross  sales  over  a  series  ol 
years,  bearing  in  mind  the  possible  change  in  accounting  prin- 
ciples.    Good   bookkeeping  suggests  thai   income  from  outside 

trees,  investments,  etc.,  be  added  in  the  income  accounl  after  nel 
profil  -  are  determined,  but  before  interest  chai   ■      ire  deducted. 

A    Typical    Income  Account 

We  giveonnexl  page  a  typical  industrial  income  account.  We 
have  noi  chosen  this  illustration  for  its  individual  character  but 
rather  becau  e  it  is  neither  extraordinarilj  complete  noi  does  it 
.ii  tempi   to  hide.     1 1   i  an  be    een   i  hal   it   follow  -  broadl)    the 


44  /  n  d  it  s  trial   Securities 

principles  laid  down  previously.  It  is  apparent  that  total  gross 
earnings  as  given  are  obtained  from  the  direct  earnings  of  the 
company  —  a  steamship  corporation : 

KERR   NAVIGATION   CORPORATION 

STATEMENT  OF  PROFITS  AND  INCOME  FOR  THE  YEAR  ENDED 

DECEMBER   31st,  1918 

Gross  Earnings  of  Steamships: 

Freights  Earned $13,237,417.10 

Charter  Hires    1,602,186.27 

Total  Gross  Earnings $14,839,603.74 

Deduct  Cost  of  Operating  Steamships  including  Agency  and 
Brokerage  Commissions,  Adjustment  of  Claims,  and  an 
Allowance  for  Depreciation  and  Accruing  Renewals.  .  .  .  4,473,912.86 

Gross  Profit  on  Operations $10,365,690.51 

Deduct  Administrative  and  General  Expenses 170,402.96 

Net  Profit  on  Operations $10,195,287.55 

Add  Miscellaneous  Income: 

Interest  on  Investments $58,810.26 

Profit  on  Investments  Realized 4,048.95 

Interest  on  Bank  Balances 52,575.84  115,435.05 

$10,310,722.60 
Deduct  Interest  Charges: 

Interest  on  Mortgage  Notes  (All  retired 

as  of  Dec.  31st,  1918) $212,760.00 

Interest  on  Floating  Indebtedness 19,093.12  231,853.12 

Net  Profits  and  Income  for  Year $10,078,869.48 

Deduct  Extraordinary  Charges: 

Federal  Income,  War  and  Excess  Profits 

Taxes  for  1917  and  1918  (estimated)     $4,612,884.54 

Amount  Applied  in  Reduction  of  First  Cost  of 
Steamers  in  Amortization  of  War  Ex- 
cess Values 4,400,512.50         9,013,397.04 

Surplus  Net  Profits  and  Income  for  Year  Carried  to 

Surplus  Account $1,065,472.44 

As  per  certificate  of  David  Elder  Co.,  dated  March  21st,  1919,  Char- 
tered Accountants  and  Auditors. 


T  h  e    I  n  c  o  m  e   A  c  c  o  u  ii  t  45 

In  its  deductions  are  included  allowances  for  depreciation  and 
renewals.  These  might  well  have  been  separated  so  that  it 
would  have  been  possible  to  see  just  what  had  been  allowed.  In- 
asmuch as  the  operating  ratio  is  very  low,  the  natural  deduction 
is  that  the  allowance  for  depreciation  and  renewals  was  not  large. 

Miscellaneous  income  is  shown  clearly  and  added  to  net 
profits  on  operations.  While  of  little  consequence  in  this  instance 
there  is  a  method  of  figuring  here  that  is  interesting.  Net  profits 
and  income  for  the  year  are  given  at  $10,000,000  from  which  are 
charged  the  Federal  income,  war  and  excess  profits  taxes  for 
two  years,  as  estimated.  This  is,  from  the  standpoint  of  the 
corporation,  the  logical  place  to  deduct  such  a  charge,  but  the 
investor  must  remember  that  income  and  all  other  types  of  taxes 
are  a  prior  charge  on  the  net  earnings  of  the  company  and  that 
the  actual  net  profits  in  this  case,  although  admittedly  pulled 
down  by  accrued  taxes,  are  roughly  $5,400,000  rather  than 
$10,000,000. 

Effects  of  Taxation 

The  effects  of  the  corporation  income  and  excess  profits  tax 
law  has  been  very  far-reaching.  It  has  offered  a  powerful  in- 
ducement to  all  corporations  to  make  the  nel  profits  or  nel  income 
as  small  as  possible,  hi  the  case  of  smaller  corporations,  where 
the  administrative  offi<  ers  are  also  the  chief,  or  perhaps  the  only 
ickholders,  the  tendency  is  to  make  salaries  and  administrative 
expenses  as  I;  possible.     The  same  pressure  shows  itsell  in  a 

policy  of  ultra-liberal  allowances  for  depreciation,  and  a  tend*  n<  \ 
i()  <  harge  what  are  really  in  part  at  leasl  capital  improve- 
ments to  repairs  and  maintenance.  The  result  is  to  reduce  the 
ratio  of  nel  earnings  to  net  sales.  This  may  give  the  impression 
tha  '  doing  business  are  mounting  faster  than  the}  really 

an-,  and  for  that  reason  musl  be  remembered  in  considering 
income  statement  3. 

Sim  e  advertisin  on  idered  a  deductible  exp<  n  e  oi  doing 

Im  ine  under  the  tax  law,  urn  penl  in  adv<  i  ti  ing  are  nol 
taxed.     Therefore,  ii  a  i  orporation  finds  it  i    making  large  profits, 


46  /  n  (1  a  s  trial   Securities 

the  management  is  very  likely  to  figure  that  it  is  better  to  spend 
the  money  in  advertising  than  to  pay  it  to  the  government.  In 
other  words,  the  government  now  pays  part  of  the  adver- 
tising bill.  Advertising  will  build  up  good-will  and  bring  future 
business,  yielding  revenue  for  distribution  in  the  happy  time  when, 
it  is  expected,  excess  profits  taxes  will  be  lower  or  will  have  gone. 
In  this  way,  while  the  ratio  of  net  profits  to  net  sales  would  be 
cut  down,  there  would  be  an  invisible  asset  of  good-will  growing 
up. 

Whether  or  not  the  amount  of  revenue-producing  good-will 
that  is  built  up  by  this  process  will  turn  out  to  be  worth  the 
enormous  sums  that  are  being  put  into  advertising  at  the  present 
time  (1920),  even  after  making  due  allowance  for  theproportion  of 
the  cost  that  is  saved  from  taxes,  is  a  question  that  only  the 
future  can  answer.  The  present  effect  is  clearly  to  lessen  the  net 
income. 

Difficulties  in  Judging  an  Income  Account 

It  is  apparent  from  the  above  that  no  hard  and  fast  rule  can 
be  laid  down  in  judging  income  accounts  any  more  than  in  the 
case  of  balance  sheets. 

There  is  one  general  principle  which,  while  it  does  not  meet 
all  the  difficulties  enumerated,  will  be  found  helpful  in  meeting 
the  more  important  of  them. 

If  both  balance  sheets  and  income  accounts  be  considered  in 
the  light  of  the  business  cycle,  it  will  be  found  that  as  a  general 
rule,  there  is  a  strong  tendency  in  times  of  prosperity,  when 
business  is  good  and  profits  are  plenty,  to  handle  accounts  in  a 
very  conservative  way.  The  tendency  then  is  to  put,  not  the 
best,  but  the  worst  foot  forward,  to  charge  against  general 
expenses  what  might  properly  belong  to  capital  account  and  to 
build  up  reserves.  The  effect  is  to  minimize  the  showing  of 
assets  and  earnings.  This  makes  the  condition  of  the  corpora- 
tion look,  on  the  face  of  it,  poorer  than  it  really  is.  In  fact,  if 
this  sort  of  thing  is  not  done,  there  is  reason  for  suspecting  the 
business  ability  of  the  management.       It  is  so  widely  practised 


The    Income   Account  47 

that  the  concern  not  following  it  will  find  itself  in  a  very  weak 
condition  relatively  when  the  pendulum  swings  back  into  the  area 
of  depression. 

On  the  other  hand,  in  dull  times,  when  earnings  are  poor, 
there  is  a  tendency  to  make  earnings  look  as  large  as  possible,  to 
charge  to  capital  what  really  belongs  to  maintenance,  to  skimp 
on  repairs,  and  even  to  include  as  income  anticipated  profits  not 
yet  realized. 

Effects  of  Changing  Conditions 

Another  point  connected  with  the  course  of  business  cycles, 
is  that  toward  the  end  of  a  period  of  prosperity,  cost  of  pro- 
duction may  be  expected  to  rise.  Raw  materials  are  high  and 
wages  have  advanced.  Furthermore,  labor  becomes  less  efficient 
at  such  times.  This  is  partly  because  the  competition  for  jobs 
among  laborers  has  given  way  to  a  competition  among  employers 
for  help,  and  under  such  conditions  discipline  is  difficult,  labor- 
turnover  increases  and  t  he  laborers  are  careless  and  disinclined  to 
sustained  effort.  Another  reason  for  the  inefficiency  of  labor  al 
such  times  is  that  the  demand  for  labor  lake-  into  employment 
the  less  efficienl  class  of  laborers  who  in  dull  times  find  it  difficult 
to  obtain  employmenl  at  all.  It  is  natural,  therefore,  for  the 
margin  of  profit  to  decline  even  though  gross  sales  continue  large. 

When  den  land  falls  and  help  is  laid  off,  these  employees  are  the 
first  to  go.  The  result  is  an  increase  in  the  average  efficiency, 
which  is  still  further  raised  by  the  fad  thai  those  who  still  retain 
employmenl  are  more  anxious  to  please  lest  they  too  be  laid  off. 
Therefore,  while  demand  is  less  the  margin  of  profil  will  increase. 

[ntere  I  rates  also  rise  toward  the  end  ol  a  business  boom. 
I  i  '.mt  customers  take  up  their  cash  discounts  and  hence  more 
capital  is  needed  jusl  when  more  is  hard  to  get.  This  shows  the 
importano  of  drawing  in  during  the  height  ol  a  period  ol  pn 
perity,  setting  up  liberal  n  ervi  rengthening  working  capital 
and  building  up  others  ise,  even  though  it  maybe  at  the  expense 
of  net  profil    for  i  he  i  ime  beii 


48 


Industrial  Securities 


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CHAPTER  VIII 
ANALYZING  CONSECUTIVE  BALANCE  SHEETS 

Use  of  a  Concrete  Example 

To  assist  the  reader  in  making  a  concrete  application  of  the 
principles  that  should  be  followed  in  comparing  the  consecutive 
balance  sheets  of  a  business  enterprise  the  statements  shown  here- 
with are  submitted.  The  corporation  used  is  engaged  in  a  metal 
stamping  business.  The  actual  figures  have  been  altered  to 
show  amounts  to  the  nearest  $100. 

Let  us  examine  the  initial  balance  sheet,  1913.  These  are  two 
points  which  should  attract  the  attention  of  any  observer  even 
without  any  inside  knowledge  of  the  business.  The  first  and 
most  striking  is  the  large  size  of  the  item  —  all  debts  —  as  com- 
pared with  the  net  quick  assets  as  shown  by  the  items  cash,  plus 
notes  and  accounts  receivable.  In  round  figures  the  company 
owed  on  notes  and  accounts  payable  S53o,000  against  net  quick 
assets  of  only  $238,000. 

Evidently  al  that  time  the  company  was  al  i  he  mercy  of  its 
creditors  if  pressed  for  payment.  The  item  Merchandise,  Ra\i 
Materia]   and   Goods   in  Process,  while  large,  does  nol   help  the 

situation  \  ery  much  because  it  is  obvious  that   t  hese  assets  could 

not  be  turned  into  cash  quickly  without  taking  severe  losses, 
at  forced  sale.  Even  taking  this  item  al  its  face  value 
gives  only  $668,000  against  a  debt  of  $536,000  a  narrow 
margin  at  best.  Apparently  the  company  was  doing  business  on 
.i  floating  debl  in  place  of  a  supplj  ol  working  capital. 

A    Poor  Situation 

A  second  point  bears  this  out.  \  compari  on  oi  the  item 
Men  handise,  Ra*  Material,  and  Goods  in  Proa  £430,000)  with 
the  item  Mel  Sales  for  the  yeai     $934,000)    how  •  that,  either 


50  /  ;/  d  us  trial  S  e  cur it  i  e  s 

the  company  had  a  large  amount  of  unsold  goods  on  hand,  or 
else  was  very  heavily  loaded  up  with  raw  materials. 

The  first  interpretation  would  indicate  poor  selling,  the  second, 
that  the  company  had  tied  itself  up  with  raw  material  which  it 
did  not  have  the  money  to  pay  for.  It  further  was  out  of  any 
reasonable  proportion  to  current  requirements  since  the  total 
sales  for  the  whole  year  were  little  more  than  double  this  amount. 
With  no  information  other  than  that  furnished  by  this  statement 
such  a  situation  is  prima  facie  evidence  of  poor  management. 

Some  Important  Changes 

The  balance  sheet  for  December  31st,  1914,  shows  several  im- 
portant changes.  The  company  is  getting  along  on  less  than 
half  the  cash  —  evidently  as  much  as  possible  has  been  used  to 
pay  debts. 

The  increase  in  Notes  Receivable  shows  that  some  long-stand- 
ing accounts  had  been  turned  into  notes  ■ —  a  good  move.  This 
might  partially  explain  the  reduction  in  the  item  Accounts  Re- 
ceivable. The  rest  is  easily  accounted  for  by  the  falling  off  in 
Net  Sales.  The  item  Accounts  Receivable  is  still  large  for  the 
amount  of  sales,  altho  without  further  knowledge  of  the  nature 
of  the  business  and  the  trade  customs  therein  we  could  draw  no 
positive  conclusion  on  this  point. 

The  reduction  in  the  item  General  Supplies  and  Fuel  shows 
that  either  this  item  had  been  over-valued  in  the  previous  state- 
ment or  else  a  pronounced  economy  had  been  effected  in  this 
regard — a  good  indication  in  either  case.  The  reduction  in  the 
item  Advertising  looks  like  better  management. 

Reduction  in  Debt  Marked 

The  most  important  improvement  is  the  reduction  in  the 
debt  to  $297,000  from  $536,000,  a  reduction  of  $239,000.  We 
naturally  want  to  know  how  this  was  done.  The  explanation  is 
found  in  the  following  facts: 

Evidently  since  the  capital  stock  has  been  increased  by 
$132,000,  the  creditors  have  been  induced  to  take  stock  to  this 


Analyzing    Consecutive  Balance   Sheets     51 

amount  in  settlement  of  their  obligations.  Notes  must  be  paid 
when  due,  interest  and  principal,  or  bankruptcy  ensues,  but 
stock  has  no  such  claim.  Stockholders  can  wait  for  dividends 
until  they  are  earned. 

The  reduction  in  cash  would  seem  to  show  that  $16,000  of 
the  debts  had  been  settled  with  cash  on  hand. 

The  reduction  of  the  item  Land  and  Buildings  from  $126,000 
to  $84,000  might  indicate  that  the  company  had  sold  property  to 
that  extent.  If  so,  the  money  has  been  used  to  pay  debts  to  the 
extent  of  $42,000  and  the  position  of  the  company  thereby 
strengthened.  If  it  can  be  ascertained  that  no  real  estate  has 
been  sold  during  the  year  then  the  valuation  of  Land  and  Build- 
ings has  simply  been  reduced.  If  a  corresponding  reduction  in 
the  debt  has  been  made  out  of  earnings  it  is  an  e\  en  more  favor- 
able development  for  that  much  padding  has  been  taken  oul  of 
the  assets  and  under-valued  assets  indicate  strength. 

Turning  Goods  into  Money 

The  reduction  of  $87,000  in  merchandise,  etc.,  would  seem  to 
indicate  that  a  portion  of  the  unsold  goods  on  hand  had  been 
worked  off — presumably  at  a  loss,  or  else  that  some  of  the  surplus 
raw  material  had  been  used  up.  This  is  especially  desirable  in 
\  iew  of  the  falling  off  in  net  sales  of  $175,000.  In  fact,  a  failure 
to  reduce  inventories  in  the  face  of  diminishing  sales  would  look 
\  ery  bad. 

The  resl  of  the  apparenl  shrinkage    in  3  is  taken  up  on 

the  liabilities  side  by  a  bold  writing  down  of  the  surplus  from 
(107,000  to  $18,000.  Values  of  assets  have  evidently  been 
courageously  deflated. 

A  Further  Strengthening 

The  ne\  i  year  [1915)  shows  a  gain  in  working  capital  repr< 
sented  by  <  ash  a    i  I     ind  a<  i  ounts  receivable  in  spite  oi  a  shrink- 
i   in  net  9ales.     An  importanl  redut  tion  in  the  inventory  item 
Merchandise,  etc.)  shows  further  ec< my  in  operation  and  .t 


52  / ;/  d  u  s  t  r  i a  1  Securities 

jettisoning  of  some  more  of  the  overload  that  contributed  to 
make  the  ship  top-heavy  in  1913. 

The  decrease  in  the  item,  Machinery  and  Dies,  shows  an 
economy  that  should  appear  in  view  of  the  smaller  volume  of 
business.  The  fact  that  this  was  not  done  the  year  before  in  the 
face  of  smaller  sales  is  the  only  weak  spot  in  the  comparison  of  the 
balance  sheets  of  1913  and  1914. 

The  statement  for  1915  shows  nearly  $90,000  more  scaled  off 
the  debts  with  no  reduction  in  surplus.  This  progressive  reduc- 
tion makes  it  evident  that  earnings  are  being  applied  to  paying 
off  the  sort  of  obligations  that  threatened  to  put  the  company 
into  bankruptcy  in  1913. 

The  1916  Year 

The  points  of  interest  in  the  balance  sheet  for  1916  are:  A 
reduction  in  Notes  Receivable,  showing  good  collections.  The 
increase  in  Accounts  Receivable  is  justified  by  the  increase  in  Net 
Sales,  as  is  also  the  increase  in  inventories. 

Machinery  and  Dies  have  been  written  down.  Since  a  larger 
business  was  done  than  in  1915  it  is  evident  that  the  producing 
power  of  the  plant  was  not  injured  by  the  reduction  in  machinery 
and  dies.  This  creates  the  probability  that  the  actual  amount  of 
useful  machinery  and  dies  has  not  really  been  reduced  at  all,  but 
that  the  valuation  of  these  items  has  been  scaled  down  to  allow 
for  depreciation  or  obsolescence. 

The  debt  continues  to  fall  and  the  surplus  shows  a  substan- 
tial increase. 

The  disappearance  of  the  item  Advertising,  in  view  of  in- 
creased business,  requires  comment.  If  the  firm  really  stopped 
advertising  it  is  not  likely  that  its  business  would  increase.  So 
we  must  infer  that  advertising  matter  on  hand  had  been  kept 
down  by  good  management  or  was  simply  ignored  in  making  up 
the  statement.  This  would  be  very  conservative  since  such 
matter  is  worth  nothing  if  the  firm  were  to  liquidate,  and  hence 
had  better  be  charged  to  expenses  and  then  forgotten  if  pos- 
sible. 


Analyzing   Consecutive  Balance  Sheets  53 

A  Very  Strong  Position 

Furniture  and  fixtures  have  apparently  been  written  down  in 
value  since  it  is  wholly  unlikely  that  the  company  is  doing  a 
larger  business  on  less  than  one-eighth  the  office  furniture  than  it 
had  in  1913.  The  item  has  probably  been  reduced  to  a  "red-flag" 
(i.e.  auction  room)  valuation,  even  though  some  may  have  been 
dispensed  with.     Good  economy  in  any  case. 

The  same  trend  is  seen  when  we  turn  to  the  1917  report. 
The  reduction  in  Accounts  Receivable  shows  improving  collec- 
tions and  makes  it  look  as  though  the  firm  was  shortening  its 
credit  lines.  Increasing  inventories  in  face  of  less  sales  does  not 
look  so  good.  But  the  further  large  reduction  in  debt  shows 
that  the  company  could  afford  to  invest  in  material  it  it 
u  ished. 

The  operation  of  the  war  revenue  laws  shows  in  the  creation 
of  reserves  for  taxes  and  dividends,  largely  at  the  expense  of 
surplus. 


The  Transition  Completed 

The  remaining  years  require  but  little  comment.  The  debts 
continue  to  fall  and  the  cash  to  rise.  In  considering  the  items 
for  the  years  1916  and  following,  il  musl  be  remembered  that 
prices  were  rising  and  larger  figures  for  Inventories,  Accounts 
Receivable,  and  Nel  Sales  should  be  expected  and  do  nol  neces- 

ilv  indicate  a  larger  volume  of  business  as  measured  in  physi- 
cal units.  Bet  ause  the  number  of  dollars'  worth  ol  business  was 
increased  greatly  many  business  men  have  fooled  themselves  into 
believing  thai  they  are  doing  more  business  when,  in  fact,  they 
are  selling  perhaps  fewer  physical  units  of  goods  bu1  getting  a 
higher  pri<  e.  The  increased  profits  in  dollars  must  be  discounted 
the  same  way,  remembering  thai  a  profil  ol  $100,000  in  a  year  in 
1914  really  bigger  and  would  buy  more  than  $175,000  in 

1918  or  1919. 

The  above  example  is  offered  becau  e  it  shows  the  transition 
under  able  management  from  a  position  ol  ini.ni.  ial  weakne  3  i<> 


54 


Industrial  Securities 


one  of  growing  strength.  This  is  the  sort  of  progress  that  should 
be  looked  for  in  comparing  balance  sheets,  as  it  is  practically  im- 
possible to  fix  up  balance  sheets,  over  a  series  of  years  so  as  to 
show  such  a  trend  unless  the  real  condition  is  improving. 


TEST   QUESTIONS 

ON 

"INDUSTRIAL   SECURITIES" 

These  TEST  QUESTIONS  can  be  answered  directly 
from  the  TEXT  discussion.  You  will  find  them  helpful 
for  purposes  of  review. 

1.  Why  are  industrial  securities  so  attractive  to  the  specu- 

lator? 

2.  What  is  the  biggest  factor  in  successful  industrial  enter- 

prise? 

3.  What  general  factors  should  be  studied  before  buying 

an  industrial? 

4.  What  individual  factors? 

5.  What  are  the  principal  points  to  look  for  in  an  industrial 

investment? 

6.  Why  can  little  weight  be  given  the  surplus  account? 

7.  What  is  working  capital?     What  does  declining  working 

capital  indicate? 

8.  What  are  the  vital  points  to  seize  upon  in  an  income 

account  ? 

9.  I  low  should  income  at  t  ounts  be  judged? 

10.  Explain  in  Balance  Sheets  on  page  18  why  cash  declined 
in  L919  and  accounl  -  receivable  increa  ■<  d 


ANALYSIS   OUTLINE   FOR   INDUSTRIAL  SECURITIES 

This  Analysis  Outline  is  given  you  to  enable  you  to 
judge  the  soundness  and  progress  of  an  industrial  enter- 
prise. The  factors  should  be  answered  to  your  satis- 
faction under  the  principles  set  forth  in  the  text. 

A.  The  Enterprise 

1.  Type 

2.  Location 

3.  Product 

(a)  Fluctuation  in  Demand 
(6)   Diversification 

4.  Source  of  Raw  Materials 

5.  Competition 

B.  The  Personal  Element 

1.  Financial  Control 

2.  Financial  Backing 

3.  Relations  with  the  Banks 

4.  Directors 

5.  Financial  Policy 

C.  The  Income  Account 

1.  Study  a  Series 

2.  Gross  Sales 

3.  Gross  and  Net  Profits 

4.  Outside  Income 

5.  Interest  Charges 

6.  Reserves 

7.  Charge  for  Depreciation 

D.  The  Balance  Sheet 

1.  A  Series  Necessary 

2.  Working  Capital 

(a)   Its  Size     (b)   Its  Growth 

3.  Fixed  Assets 

(a)  How  Valued?     {b)  Relation  to  Working  Capital 

4.  Treasury  Investment 

(a)  Size     (b)  Soundness 

5.  Patents,  Etc.,  Overvalued 

6.  Current  Liabilities 

(a)   Relation  to  Fixed     (b)  Growth 

7.  Reserves 

(a)  Liberal     (b)  How  Invested? 

8.  Surplus 

Earned,  or  Has  Plant  Been  Marked  Up? 


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KEY  PROBLEM  FOR  INDUSTRIAL  SECURITIES 

Note  the  Balance  Sheets  on  opposite  page.  They  are  for  one  of  the 
leading  Industrial  Corporations  of  the  country.  Analyze  in  the  light  of 
what  you  have  learned  in  the  last  chapters  of  this  Text. 

1.  Has  the  position  of  the  company  improved  in  five  years?     If  so,  how? 

2.  Do  you  consider  its  working  capital  at  the  end  of  the  period  strong 
or  weak? 

3.  What  is  the  relation  of  Inventory  to  total  current  assets?  Of  Bills 
Receivable? 

4.  Note  changes  in  capital  structure.     What  have  they  done? 

5.  How  has  working  capital  been  built  up? 

6.  Is  that  method  good  business? 

7.  What  made  the  surplus  decline  so  rapidly? 


Garden  City  Press,  Inc~ 
Newton,  Mass. 


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